The world economies are increasingly intermingled together. What happens in one country can have effects felt in other countries around the world. The effects of globalization are causing an increased focus onto exchange rates not just by corporations, but by individuals as well. The internet has made it super easy to purchases goods and services from anywhere in the world. Every transaction is governed by an exchange rate between two currencies that specifies a conversion rate from one currency to another. For example, if an Australian citizen wanted to purchase an item from the United Kingdom, the Aussie Dollar converts into Pounds in order to transact the purchase.
Types Of Exchange Rates
There are two basic types of exchange rates. There is the spot exchange rate, which refers to the current value of one currency vs. another. This is no different from a current quote of a public company listed on a stock exchange. In addition to the spot rate, there is the forward exchange rate. This exchange rate is set today for delivery at a future date. A forward rate is especially important for exporters of commodities such as gold, wheat, and cotton to name a few. Exchange rates move over time, and miners and farmers usually prefer to lock in an exchange rate now rather than deal with the uncertainty of where it will be in the future.
When quoting any currency, there is a bid price and an ask price. The bid reflects the highest price buyers of the currency are willing to pay. The quoted ask reflects the lowest price sellers are willing to offer the currency at. All currencies are quoted in pairs. This means a currency quote is an exchange vs. another currency. The quote is always the amount of a "payment" currency that converts into the "base" currency. From the example mentioned earlier, one must convert AUD into GBP to make a purchase. In order to find the exchange rate, one would look for the GBP/AUD quote or use an exchange rate calculator. The base currency quotes first, with the payment currency quoted second. If the GBP/AUD quote is .6877, this would mean for every 1 Australian dollar, you will receive .6877 British pounds.
When looking to convert currencies, a very handy tool many use is an exchange rate calculator. This makes it very easy to convert one currency to another without the hassle of trying to remember base vs, payment currency. This can get increasingly complicated when one currency is not readily convertible into another. This requires an intermediary currency, which means A to B to C. Without using an exchange rate calculator these computations can get difficult. Additionally, many businesses sell products globally. This requires the constant monitoring of exchange rates that change daily.
It is important to note that currency quotes are a direct quotation or an indirect quotation, depending on the country providing the quote. Most currency quotes are four digits in length. Quotes which use the home currency of a country as the price currency, such as EUR 0.75432 = AUD 1.00 in the euro zone, are a direct quotation. Other countries such as Australia, New Zealand and others will use an indirect quotation, such as AUD 1.00 = EUR 1.3245
Floating Vs. Pegged
Another important aspect to remember about currencies is some currencies float freely without intervention or manipulation, while others are pegged to a fixed value. Free-floating currencies are subject to normal supply and demand for that currency. In general, the stronger the GDP and balance sheet of the home country, the stronger the currency compared to others. On the other hand, there are countries around the world that do not allow the currency to float. The value is an artificial value set by the government or banking authorities, which is known as “pegging”. This can cause problems when trade imbalances happen. One country will make extra gains at the expense of another because of an artificial exchange rate.
Fluctuations In Rates
Exchange rates fluctuate constantly, and are subject to wild gyrations based upon global economic news. It is not uncommon to see a currency appreciate or depreciate by 1 percent in a single day compared to other currencies. Over a period of months, a currency can move as much as 10 or 15 percent from a prior value. This constant currency movement provides the volatility that brings in traders to the tune of over $1 trillion changing hands each day.