Foreign Exchange Rates Essay
IntroductionForeign exchange is said to be the currencies of all other countries within any one country. Foreign exchange rate is actually the price of foreign currencies for delivery on a value date sometime in future. Whenever one functions in the money and foreign exchange markets, one is constantly giving and taking whenever one goes into a transaction. In this paper, I shall express how the price, or rate of exchange, in this giving and taking is expressed.
Body of PaperPrimarily the exchange rates in a country are determined by its economic strength. Like in every other market, prices in foreign exchange market are driven by the act of the trader that is if the operator is a buyer or a seller. Traders in these markets at all times present two prices: the one upon which they are agreeable to buy and the one upon which they are agreeable to sell. This is essentially one of the ways as a result of which traders in these markets get a return. Prices of foreign exchange in a given country are stated in the same manner as the price of any good or service in that country, which is in terms of their local currency. For example, in the United States, one expresses the price of goods and services in the U.S. dollars.
This applies to cars, dishwashers, medical services, and everything else; it also to applies to foreign exchange. For example, one can say the price of a car is $3,000 or the price of one Saudi Arabian Riyal is $0.26.In contrast to the money market, where quotations are expressed in percentage form, the prices in the foreign exchange market are expressed in terms of units of local currency.
Every price quotation answers two questions:What are we trying to price (houses, tomatoes, and foreign currency)?What unit of account or currency are we using to express the price? ) Usually, it is the domestic currency.)When one asks for a quotation of the price of foreign exchange, one must be careful to understand what the unit of account used is. The Saudi Arabians will quote in terms of the Saudi Arabian Riyals, the Venezuelans in terms of Bolivars, and in Singapore the quotes will be in terms of the Singapore dollars. When quotations are expressed in terms of the Saudi Arabian Riyals, they are called ‘Saudi Arabian Terms’. When quotations are expressed in terms of the U.S. dollars per unit of foreign currency, they are called ‘American Terms’.Exhibit ACarTomatoOne Dollar BillNew York$7,600$0.
30$1.00JeddahSAR 28,500SAR 1.125SAR 3.75SingaporeS$ 11,673S$ 0.
4608S$ 1.536Exhibit A shows how the prices of cars, tomatoes, and a $1 bill are expressed in three different cities. In New York, using American terms, the price of a certain car is $7600, the price of a tomato is $0.
30, and the price of $1 bill is $1. In Jeddah, using the Saudi Arabian terms, the prices of these three items are SAR 28,500, SAR 1.125 and SAR 3.75, respectively.
The exhibit also shows these prices using the Singaporean dollars, Singaporean terms.The column to the right of Exhibit A is of particular interest in my discussion of this paper. In this column, I have shown that the price of a $1 bill is SAR 3.75 or S$1.536, depending on what terms we use. By pricing a $1 bill, we have actually provided the exchange rates between the dollar and the currencies used as the unit of account in the other countries.The exchange rates in the right column of Exhibit A are given in local terms. However, by making use of some simple arithmetic, we can change the terms in which the quote is given.
For example, if we know that the price of $1 is SAR 3.75, we can find the price of SAR 1 in terms of dollars, that is, express SAR in American terms. The price of SAR 1 in American terms is $0.266 ($1 / SAR3.75). The $0.
266 is called the ‘reciprocal rate’ of the original quotation.To illustrate foreign exchange rates further, consider a tourist. An American tourist will continue thinking in terms of her home currency, U.
S. dollars, even though the price tags of articles in foreign country would be expressed in that country’s local currency. For the American to understand the price of an item in terms of the U.
S. dollars, which is what she understands, a mental translation has to be made. If the price of an item is ?50, the American tourist is likely to want to know what that means in terms of the U.S. dollars.
In this case the item may cost about ?100 if the price of ?1 at the time is $2 (?50 * $2 per pound = $100). The same American tourist, after leaving England, now goes to Australia. At the airport in Australia, she wishes to exchange $100 of traveler’s checks into Australian dollars. When presenting the checks to be exchanged, she asks what the going exchange rate is. The reply is 1.26. The tourist is used to prices expressed in terms of the U.
S. dollars. However, the quote she has been given is expressed in terms of Australian dollars, the local currency in Australia. Specifically, the quote means AUD1.26/$. If the tourist wishes to convert the 1.26 quote from Australian to American terms, she just takes the reciprocal of 1.
26. Thus, the quote can be expressed in two ways:Australian Terms American TermsAUD1.26/$ $0.79/AUDTherefore, the correct way to ask the price of a certain currency against another is to do that expressed in a certain country’s terms. If no special terms were requested, the trader would give the quote in the country local to the trader himself.The system of quoting foreign exchange rates as mentioned in the preceding pages is called the ‘price quotation system’. Under this system, prices are quoted in local currency for an even amount such as 1,100, or 1,000 units of foreign currency, for example, $26 per SAR100. The even foreign currency amount remains unchanged, and the rate fluctuations are reflected in changes in the price in local currency per unit size of foreign currency.
The British, however, do not have the price quotation system: instead they use the ‘volume quotation system’. In this system the even unit that does not change is ?1, and the value of foreign currencies is expressed through the amount (volume) of a given foreign currency that is required to purchase ?1. For example, assume the rate for U.S. dollars against British pound is $2 per pound. In the United States, this represents a price quotation because the value of an even amount of foreign currency, such as one British pound, is expressed in local currency, as US$2.However, in London an even amount of local currency, such as one British pound, is equal to a variable amount of foreign currency, that is, US$2.
If this rate moves from $2 to $1.9 per pound, people in United States will say, “The pound went down,” because the value of the pound decreased from US$2 to US$1.9. At the same time people in England will say, “The dollar went down up,” because it now takes only US$1.9 to purchase ?1.Before the U.S.
dollar moved into its position as the most commonly used currency for international trade, this position was held by the pound sterling. It is probably for that reason that the British adopted the volume quotation system. This system expresses rates in terms that are readily understood by local traders outside Britain. Because of the prominence of the U.S.
dollar today, it would probably be desirable for the United States to adopt the volume quotation system for the same reason.Business people often talk about exchange exposure or exposure to exchange rate risk. Exposure to exchange rate risk means a potential for gains or losses if exchange rates fluctuate. In foreign exchange transactions the rate risk appears in two forms:In net exchange positions,In swap positions or mismatched maturities.
The most obvious case of rate risk is the maintenance of a ‘net exchange position’ in a given currency. If the position is long or overbought and there is depreciation of the currency, a loss is sure to occur. The opposite results would occur if the net exchange position were short or oversold in that currency. The other way when rate risk appears when one operates in the foreign exchange market is through ‘swap positions’. A swap involves a simultaneous buy and sale of currency for two different maturities. It is important to hedge against such rate risks.ConclusionIn this paper, I have attempted to explain what foreign exchange rate is and how the changes in it are perceived as in different countries with different currencies. It is important that anyone entering into a foreign exchange transaction is well aware of not only the prevalent foreign exchange rates but also the forward rates (those of future) in order to avoid any potential losses.
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