Study notes

Exchange Rates - An Introduction

An exchange rate is the price of one currency in terms of another – in other words, the purchasing power of one currency against another.

Currencies are traded in foreign exchange markets and the volume of money bought and sold is huge! Daily foreign exchange market turnover averages over $4 trillion

Exchange rates are an important instrument of monetary policy – a growing number of countries are intervening in currency markets as part of their economic strategies

Measuring the exchange rate

Exchange rates are expressed in various ways:

  • Spot Exchange Rate - the spot rate is the rate for a currency at today’s market prices
  • Forward Exchange Rate - a forward rate involves the delivery of currency at a specified time in the future at an agreed rate. Companies wanting to reduce risks from exchange rate volatility can buy their currency ‘forward’ on the market
  • Bi-lateral Exchange Rate - the rate at which one currency can be traded against another. Examples include: $/DM, Sterling/US Dollar, $/YEN or Sterling/Euro
UK Sterling Exchange Rate v the US Dollar
  • Effective Exchange Rate Index (EER) - a weighted index of sterling's value against a basket of currencies the weights are based on the importance of trade between the UK and each country.
  • Real Exchange Rate - this is the ratio of domestic price indices between two countries. A rise in the real exchange rate implies a worsening of competitiveness for a country
Effective Exchange Rate Index for Sterling

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