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Investment - Foreign Exchange Rate Systems
International trade requires a system for transferring currencies across nations because every country does not utilize the same form of money. To pay for items from another country, money from one country must be changed into the currency of another country.
International trade needs payments between countries. These payments involve an exchange of currencies and are affected by international exchange rates and foreign exchange rate systems.
The rate at which a unit of one currency can be exchanged for a unit of another currency is referred to as the foreign exchange rate or exchange rate. An exchange rate is expressed as the number of units of one currency it takes to convert into the other currency.
International commerce payments may be done in the country’s own currency or in a foreign currency. Assume a supermarket chain located in France imports dairy products from the United Kingdom and has to pay the UK producers in British pounds. The exchange rate between the pound and the euro is commonly given in euros per pound (EUR/GBP).
An exchange rate of EUR1.20/GBP1 means that it takes 1 euro and 20 cents to acquire 1 pound. If the French grocery chain has to make a payment of GBP100,000 to the UK producers, it will need to exchange EUR120,000 to obtain GBP100,000 (£100,000 × €1.20/£1).
The exchange rates between world currencies, such as the US dollar (USD), euro (EUR), British pound (GBP), and Japanese yen (JPY), are like the pricing of goods and services. Like most commodities and services, exchange rates move frequently depending on supply and demand. If a lot of people desire to acquire a certain currency, such as the euro, demand for the euro will increase and the price of the euro will rise, or appreciate, relative to other currencies; consequently, it will take more of another currency to buy a euro.
Alternatively, if the euro falls out of popularity, demand for the euro would diminish and the price of the euro will fall, or depreciate, relative to other currencies.
There are three primary types of exchange rate systems:
Fixed rate
Floating rate
Managed floating rate
At the Bretton Woods conference in 1944, the major nations of the Western world agreed on an exchange rate system in which the value of the US dollar was defined as USD35 per ounce of gold. That is, a dollar was equivalent to one thirty-fifth of an ounce of gold. All other currencies were defined with relation to, or ‘pegged’ to, the US dollar.
Such a system of exchange rates, which does not allow for volatility, is known as a fixed exchange rate system.
The advantage of a fixed exchange rate system is that it removes currency risk (or foreign exchange risk), which is the risk connected with the fluctuation of exchange rates.
In a fixed-rate environment, importers and exporters know with certainty the amount that they will pay or get for the items and services they trade.
A downside of a fixed-rate regime is that, as the competitiveness of countries varies over time, an economy that becomes uncompetitive would see its current account balance worsen because its currency gets overvalued. Its exports are too expensive from the buyer’s standpoint, while its imports are too cheap from the seller’s perspective. Under a fixed exchange rate system, the only answer to this dilemma is for the government to legally depreciate its currency.
Devaluation is the decision made by a country’s central bank to decrease the value of the domestic currency relative to other currencies, an action that many governments are reluctant to perform.
To overcome the problems of a fixed exchange rate system, the Bretton Woods agreement was abandoned in 1973, and currency values were left to fluctuate up and down, or float, with the market forces of supply and demand. Since 1973, the major currencies have existed under a floating exchange rate regime. In a fully floating exchange rate system, a country’s central bank does not intervene and allows the market determine the value of its currency. Under this structure, the exchange rate between the domestic currency and foreign currencies is exclusively driven by the supply of and demand for each currency.
In a controlled floating exchange rate regime, a central bank intervenes to stabilise its country’s currency. To strengthen the domestic currency, it buys domestic currency using foreign currency reserves, or it buys foreign currency using domestic currency to weaken the domestic currency.
In the wake of the European sovereign debt crisis in 2012, many investors switched their euros to Swiss francs, perceiving the Swiss franc as a safer currency than the euro. The rise of the Swiss currency started weakening the competitiveness of Swiss exporters and led the Swiss National Bank, Switzerland’s Central Bank, to interfere.
To drive the price of the Swiss franc down, the Swiss National Bank sold its own currency and bought foreign currencies, such as the euro; in other words, the Swiss National Bank did the reverse of what investors were doing. In the process, it accumulated foreign cash reserves.
This example indicates that central banks do not usually aim for a perfectly fixed exchange rate, but typically endeavor to maintain the value of their country’s currency within a particular range. Central banks tend to intervene infrequently, therefore generally, such a system runs as a floating exchange rate system.
International trade requires a system for transferring currencies across nations because every country does not utilize the same form of money. To pay for items from another country, money from one country must be changed into the currency of another country.
International trade needs payments between countries. These payments involve an exchange of currencies and are affected by international exchange rates and foreign exchange rate systems.
The rate at which a unit of one currency can be exchanged for a unit of another currency is referred to as the foreign exchange rate or exchange rate. An exchange rate is expressed as the number of units of one currency it takes to convert into the other currency.
International commerce payments may be done in the country’s own currency or in a foreign currency. Assume a supermarket chain located in France imports dairy products from the United Kingdom and has to pay the UK producers in British pounds. The exchange rate between the pound and the euro is commonly given in euros per pound (EUR/GBP).
An exchange rate of EUR1.20/GBP1 means that it takes 1 euro and 20 cents to acquire 1 pound. If the French grocery chain has to make a payment of GBP100,000 to the UK producers, it will need to exchange EUR120,000 to obtain GBP100,000 (£100,000 × €1.20/£1).
The exchange rates between world currencies, such as the US dollar (USD), euro (EUR), British pound (GBP), and Japanese yen (JPY), are like the pricing of goods and services. Like most commodities and services, exchange rates move frequently depending on supply and demand. If a lot of people desire to acquire a certain currency, such as the euro, demand for the euro will increase and the price of the euro will rise, or appreciate, relative to other currencies; consequently, it will take more of another currency to buy a euro.
Alternatively, if the euro falls out of popularity, demand for the euro would diminish and the price of the euro will fall, or depreciate, relative to other currencies.
There are three primary types of exchange rate systems:
Fixed rate
Floating rate
Managed floating rate
At the Bretton Woods conference in 1944, the major nations of the Western world agreed on an exchange rate system in which the value of the US dollar was defined as USD35 per ounce of gold. That is, a dollar was equivalent to one thirty-fifth of an ounce of gold. All other currencies were defined with relation to, or ‘pegged’ to, the US dollar.
Such a system of exchange rates, which does not allow for volatility, is known as a fixed exchange rate system.
The advantage of a fixed exchange rate system is that it removes currency risk (or foreign exchange risk), which is the risk connected with the fluctuation of exchange rates.
In a fixed-rate environment, importers and exporters know with certainty the amount that they will pay or get for the items and services they trade.
A downside of a fixed-rate regime is that, as the competitiveness of countries varies over time, an economy that becomes uncompetitive would see its current account balance worsen because its currency gets overvalued. Its exports are too expensive from the buyer’s standpoint, while its imports are too cheap from the seller’s perspective. Under a fixed exchange rate system, the only answer to this dilemma is for the government to legally depreciate its currency.
Devaluation is the decision made by a country’s central bank to decrease the value of the domestic currency relative to other currencies, an action that many governments are reluctant to perform.
To overcome the problems of a fixed exchange rate system, the Bretton Woods agreement was abandoned in 1973, and currency values were left to fluctuate up and down, or float, with the market forces of supply and demand. Since 1973, the major currencies have existed under a floating exchange rate regime. In a fully floating exchange rate system, a country’s central bank does not intervene and allows the market determine the value of its currency. Under this structure, the exchange rate between the domestic currency and foreign currencies is exclusively driven by the supply of and demand for each currency.
In a controlled floating exchange rate regime, a central bank intervenes to stabilise its country’s currency. To strengthen the domestic currency, it buys domestic currency using foreign currency reserves, or it buys foreign currency using domestic currency to weaken the domestic currency.
In the wake of the European sovereign debt crisis in 2012, many investors switched their euros to Swiss francs, perceiving the Swiss franc as a safer currency than the euro. The rise of the Swiss currency started weakening the competitiveness of Swiss exporters and led the Swiss National Bank, Switzerland’s Central Bank, to interfere.
To drive the price of the Swiss franc down, the Swiss National Bank sold its own currency and bought foreign currencies, such as the euro; in other words, the Swiss National Bank did the reverse of what investors were doing. In the process, it accumulated foreign cash reserves.
This example indicates that central banks do not usually aim for a perfectly fixed exchange rate, but typically endeavor to maintain the value of their country’s currency within a particular range. Central banks tend to intervene infrequently, therefore generally, such a system runs as a floating exchange rate system.
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