What You Should Know About an Exchange Rate

The exchange rate of a currency is the price of a currency against another, also known as the parity of a currency. The exchange rates quoted on currency markets vary incessantly depending on a number of factors including the listing venue.

The spot exchange rate relates to the exchange rate at a given time, while the forward exchange rate points to a rate quoted and traded on a particular day but whose delivery and payment are earmarked for a future date.

The exchange rate is determined by supply and demand of the currencies involved, if demand exceeds supply, the price increases. And since the currency of a country is basically an obligation of the central bank of that country, the detention of a foreign currency can be seen as holding a claim in the view on the country it was issued.

The exchange rates vary widely during a single day, and these variations can not be explained by the theory of purchasing power parity (PPP). These daily changes are based on the concept of early return of deposits in foreign currencies. Economic agents determine the demand for different currencies depending on the profitability anticipated from deposits in these currencies.

An exchange system quotation is presented by expressing the number of units which can be exchanged for one unit of the base currency, for example, EUR/ZAR exchange rate is 11.4320 (11.4320 ZAR per EUR).

A country will suffer a currency crisis when the capacity to repay external debt (public and private) denominated in foreign currency is highly questionable (confidence crisis). The outflow of capital in the short term is then dropped by the exchange rate of the currency, making repayment even more difficult.

Exchange rates and interest rates, which are closely related act naturally on import and export prices. They have an influence on the direction of capital flows between economic zones.

As a result, countries and economic areas may be tempted to influence exchange rates, often under the guise of preventing speculation. The decline in the exchange rate can also have negative effects such as higher import prices, etc.

Whenever a currency is free floating, its exchange rate is permitted to change versus other currencies, and this is influenced by market forces. Bilateral exchange rate entails a currency pair, and a country’s external competitiveness is determined by the effective exchange rate which is the weighted average of a pool of foreign currencies.

In the long term, currencies should theoretically approach the equilibrium exchange rates obtained from structural parameters. Imbalances and the balance in currency valuation is measured from purchasing power parity (PPP). It is a complex statistical exercise, which is used to compare over time the purchasing power of a typical consumer in a given country, against a range of consumer data of consumers in another country.