Thursday, August 5, 2010

Exchange Rates What are they exactly?

The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.

How the currency exchange rate is calculated?
There are various factors that determine an exchange rate. Trade value, inflation, and interest rates, to name a few. These are basic principles to help understand the concept.

Let's work in a closed vacuum and assume there is no inflation between two countries or any other factors and examine fluctuations based on wealth and trade.
We begin with country A, which lets call the USA and country B which we call Britain. Lets imagine that 1 UD Dollar = 1 British Pound.

Now let's say that the Americans own $100 and the British own 100 Pounds. If America buys $5 worth of product from Britain, America would have $95 and Britain would have 105 Pounds. Suddenly Britain becomes wealthier. In theory Britain is approximately 10% wealthier now. (100/95x105=10.52%) So suddenly $1 would be worth around 1 Pound and 10 Pence.

This is the principle of trade surpluses and trade deficits and wealth within a currency.

Now let's imagine that America and Britain each have $100 again. Let's say that over 1 year, prices in America stayed the same but in Britain, prices went up 5%. We would now have an effect where Britain is 5% poorer then America and $1 would be now worth 1 Pound and 5 Pence. This is where interest rates are determined. Britain could have helped keep $1 worth 1 Pound by having an Interest rate of 5%.

Interest rates are determined normally by a Reserve Bank governor that determines economic policy for a currency. Interest rates can also be manipulated to stimulate an economy by strengthening or weakening a currency.

Now we can also consider what would happen if Britain deicide to print twice as much money as it had before. If America and Britain each has $100 and 100 Pounds each respectively, and Britain decided to print 200 Pounds in an attempt to get wealthier, suddenly $1 would equal 50 pence. However if Britain had found 100 Pounds of gold and was worth 200 Pounds, then $1 would still equal 1 Pound.