Learn How to Understand Exchange Rates

Learn how to understand exchange rates and the factors that influence them

how to understand exchange ratesStudents taking finance course often encounter difficulties with some areas of the course. Most areas you will study in finance require good quantitative and analytical skill and not every student is talented in that area. The finance homework service we offer can assist students who are having problems with any aspect of their finance homework. Exchange rates are something most people don’t give much thought to unless they happen to be traveling to another country.

However, it is important that you understand exchange rates, what influences them and the effect they have as they often play an important part in finance and the economy. Exchange rate is the price of a nation’s currency (domestic currency) in terms of another currency (foreign currency).

Exchange rates may be quoted in one of the following ways:

  • Direct quotation: The price of a unit of foreign currency is expressed in terms of the domestic currency.
  • Indirect quotation: The price of a unit of domestic currency is expressed in terms of the foreign currency.
  • Cross currency/cross rate: An exchange rate that does not have the domestic currency as one of the two currency components

Tips on how to understand exchange rates

A good way how to understand exchange rates is to become familiar with some of the elements that influence exchange rates, and the effect that rates have on business. Knowing these fundamentals will help you with your exchange rate assignments. Keep theses ten tips/rules in mind when working with exchange rates:

  1. Inflation rates influence exchange rates. Countries with lower inflation rates will generally see an appreciation in the value of their currency.
  2. Higher interest rates result in the value of a countries currency appreciating as it becomes more attractive to deposit money in a country with higher rates of interest.
  3. Speculation can result in movement in the exchange rate that doesn’t always reflect economic fundamentals. If speculators believe a currency will increase in value they will buy more, thus increasing demand and making the currency appreciate.
  4. Appreciation in the exchange rate makes exports more expensive
  5. Depreciation of the exchange rate makes exports cheaper and benefits companies that export goods, but increases the cost of imported materials
  6. Using fixed contracts to buy imported materials can nullify the effects of temporary fluctuations in the exchange rate so cost of imported materials won’t change.
  7. Floating exchange rates occur when the value of the currency is determined by market forces.
  8. Real exchange rate (RER) is the purchasing power of a currency relative to another at current exchange rates and prices. A RER of 1 means that an item costs the same in either currency if a common currency is used
  9. A different buying rate and selling rate will always be quoted by money dealers in the retail currency exchange market.
  10. Currency tends to follow the laws of supply and demand like any other commodity. As the supply of a currency increase the currency will depreciate, and appreciate as the supply decreases.

Although it is not 100 percent sure the above will always hold true, they are in most cases, unless influenced by other factors.

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