Exchange Rate
Quick Definition
The price of one currency expressed in terms of another, determining how much of one currency is needed to purchase a unit of another.
Key Takeaways
- The price of one currency in terms of another
- Floating rates are determined by supply and demand in forex markets
- The forex market trades over $7.5 trillion daily—the world's largest
- Influenced by interest rates, inflation, trade balances, and capital flows
- Central banks may intervene or fix exchange rates for policy objectives
What Is Exchange Rate?
An exchange rate is the rate at which one currency can be exchanged for another. Exchange rates can be quoted directly (domestic price of foreign currency, e.g., 1 EUR = 1.10 USD) or indirectly (foreign price of domestic currency). Under a floating exchange rate regime, rates are determined by supply and demand in the foreign exchange market—the world's largest financial market with over $7.5 trillion in daily turnover. Key factors influencing exchange rates include interest rate differentials, inflation differentials, trade balances, capital flows, political stability, and market sentiment. Exchange rates affect import/export competitiveness, corporate earnings from international operations, the returns of foreign investments, and a country's debt burden if denominated in foreign currencies. Central banks may intervene to influence exchange rates or adopt fixed/managed float regimes.
Exchange Rate Example
- 1The EUR/USD exchange rate fell from 1.22 to below parity (0.99) in 2022 as the Fed raised rates aggressively while the ECB lagged behind.
- 2A weaker dollar makes U.S. exports more competitive abroad—when the dollar index fell 10%, S&P 500 companies with significant international revenue saw earnings boosts.
- 3Japan's central bank intervened in the forex market by selling dollars to support the yen after it weakened past 150 per dollar.
Related Terms
Currency Peg
A fixed exchange rate policy where a country ties the value of its currency to another currency or basket of currencies at a set rate.
Purchasing Power Parity (PPP)
An economic theory that compares currencies based on how much a standardized basket of goods costs in each country.
Interest Rate Parity (IRP)
An economic theory stating that the difference in interest rates between two countries equals the expected change in exchange rates between their currencies.
Capital Flows
The movement of money for investment, trade, or business operations between countries, including foreign direct investment, portfolio investment, and bank lending.
Trade Deficit
A situation where a country's imports of goods and services exceed its exports, resulting in a negative balance of trade.
Forex (Foreign Exchange)
The global decentralized market where currencies are traded against one another, operating 24 hours a day across major financial centers.
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