A foreign exchange rate is the price of one currency expressed in terms of another currency. A foreign exchange quotation (or quote), on the other hand, is a statement of willingness to buy or sell at an announced rate: Quotation of banks' rates.
In the retail market (newspapers, airports, etc..) quotes are most often given as the home currency price of foreign currency.
A Cross Exchange Rate is an exchange rate between two currencies, A and B, neither of which is C. It can be calculated as the ratio of the exchange rate of A to the dollar, divided by the exchange rate of B to the dollar.
Interbank Quotations
US dollar is major worldwide currency involved in the most of the foreign exchange transactions. This caused professionals dealers and brokers to state foreign exchange quotations in different ways. There have been two ways of representing foreign exchange rates worldwide for US $. Countries use any one of these two methods to announce foreign exchange rates in the markets.
First, majority of the countries express foreign exchange prices for one US dollar which is known as European terms. The following quote is an example to European terms:
Y105.00 / US $ or 1 US $ : 105.00 Y
This quote shows the amount of Japanese Yen that can be purchased for one US $ which can be also named as Japanese terms. Additionally, when for example, TL is expressed in terms of US $, the quote is said to be in Turkish terms. European terms were adopted in 1978 to facilitate worldwide trading through telecommunications.
Second, several countries express US dollar price for one unit of other currencies which is known as American terms. The following quote is an example to American terms:
US $ 0.0095 / Y or 1 Y : 0.0095 US $
The above quote shows the amount of US $ that can be purchased for one Japanese Yen which can be calculated by taking the reciprocal of the rate presented in European terms. Therefore,
American terms of presenting quotes are used for the U.K. pound sterling, the euro, Australian dollar, New Zealand dollar and Irish punt.
Direct and Indirect Quotas
Foreign exchange rates can be expressed in terms of currencies other than US$. There are two common methods other than European and American terms: Direct quote and Indirect quote.
A direct quote is a quotation expressing home currency price in terms of a foreign currency where an indirect quota is a quotations expressing foreign currency price in terms of a home currency. Consider the following rates:
EURO 1.47 / GBP or 1 GBP: 1.47 EURO
This rate shows the amount of EURO that can be purchased for one British pound sterling. It is a direct quote in EURO area showing the internal value of EURO for one unit of pound sterling and is an indirect quote in U.K. showing the external value of British pound sterling against EURO.
Taking the reciprocal of this quotation, we get:
GBP 0.68 / EURO or 1 EURO: 0.68 GBP
This quotation shows the amount of GBP that can be purchased for one EURO. It is this time a direct quote in U.K. showing the internal value of GBP for one unit of EURO and is an indirect quote in the EURO area showing the external value of EURO against GBP.
Bid and Ask (offer) Quotations
Interbank quotations are given as a bid and ask. A bid is the price in one currency at which a dealer will buy another currency. On the other hand, an offer (ask) is the price at which a dealer will sell the other currency. To make profit, bid price is greater than ask price. The difference between the two will give the spread (profit). Bid of one currency is the offer of opposite currency at the same time. A trader seeking to buy $ with EURO is simultaneously offering to sell EURO for $.
Quotes can be given in the first term (bid) as 118.27. In the second term (offer), they may be given as 118.27 – 37 on a video screen. Or 27 to 37 assuming that leading digits (118.) are already known. The last 2 digits are small figure frequently changing, while leading digits are big figures seldom changing.
When quotations are converted from European terms into American terms, bid and offer reverse. Reciprocal of bid becomes offer and reciprocal of offer becomes bid. To make a profit, offer price should be greater than the bid price.
Expressing Forward Quotations on a Points Basis
Traders usually quote forward rates in terms of points (swap rates). A point is the last digit of a quotation. Currency prices for $ are usually expressed to 4 decimal points. A point = 0.0001 of most currencies. Japanese Yen and Italian Lira are quoted to 2 points. A forward quotation expressed in points is not a foreign exchange rate as such. It is the difference between the forward rate and the spot rate.
Traders follow an operational rule that indicates whether forward quote is at a premium or a discount. More specifically, if bid in points is greater than offer in points, forward rate is said to be at a discount and points should be subtracted from spot rate. On the other hand, if bid in points is less than offer in points, forward rate is said to be at a premium and points should be added to spot rate. A forward bid and offer quotation expressed in points is also called a swap rate (Borrowing a short term loan of one currency at another currency's rate).
Forward Quotations in Percentage Terms
Forward quotations can be represented as percentage terms per annum which simply show a deviation from the spot rates per annum. This method facilitates comparing premiums or discounts in the forward market.
Here EURO currency is assumed as home currency where U.S. dollar is assumed as foreign currency. Then, percentage terms take the following forms:
Balance Of Payments and Exchange Rates
A nation’s economic performance is best viewed in BOP data. It is a statistical statement that systematically summarizes, for a specified time period, the economic transactions of an economy with the rest of the world. Economic transactions include exports, imports, income flows, capital flows, gifts and similar one-sided transfer payments. The net of all of these transactions is matched by a change in the country’s international monetary reserves. BOP are important to business managers, investors, consumers, and government officials because the data influence and are influenced by other key macroeconomic variables such as GDP, employment, price levels, etc.. Monetary and fiscal policy must take BOP into account at the national level. BOP helps to forecast a country’s market potential, especially in the short run. A country experiencing a serious BOP deficit is not likely to expand imports. BOP is an indicator of pressure for a country’s foreign exchange and for a firm for foreign exchange gains or losses.
Measuring a Nation’s Performance: Deficits and Surpluses in BOP
BOP measures, summarizes and states all the financial and economic transactions between residents of one country and residents of the rest of the world. If a nation receives less than what it spends, then it incurs a “deficit”. If a nation receives from abroad more than it spends, then it incurs a “surplus”.
Credits: Foreign Exchange Earned
Transactions that earn foreign exchange are recorded in BOP as a “credit” with a (+) sign.
Credits are obtained by selling to non-residents either real or financial assets or services. Ex. Borrowing, Exports and foreign students university fees, etc..
Debits: Foreign Exchange Expended
Transactions that expend foreign exchange are recorded as “debits” and are marked as (-) sign. Ex. Imports, purchasing foreign services (insurance), lending, host country student fees for foreign schools, etc…
BOP is systematically defined and summarized by International Monetary Fund (IMF) institution by setting up its own standard in representing BOP for the countries. According to IMF classification of BOP, there are 43 lines representing economic transactions of the countries.
Approaches in Balancing BOP
The basic aim of countries is to arrive at a zero balance in their BOP. But having a zero balance in BOP is almost impossible for countries. It is not so easy to balance foreign-based expenditures with foreign-based receipts. Imbalances in BOP will affect the whole economy of countries and their relationships with the world.
There are various policies that countries may follow in case of imbalances (surpluses or deficits) in BOP. If there are temporary deficits in BOP, these deficits could be financed by reserves or to apply a repairing policy. But if deficits are chronic or continuous, then financing through reserves might not be possible; because the international reserves of countries are not unlimited. One of the ways to put a pressure on BOP deficits is to limit foreign trade and exchange rate transactions through custom tariffs, quotas, and limiting foreign exchange transactions. The aim in this case is to narrow import volume and to prevent capital outflows. However, this strategy even does not stop deficits but put a pressure on these deficits. And this type of strategies is against liberalization trends and policies in a globalized world. And it is against the policies of World Trade Organization (WTO) and IMF.
So there are some other alternatives repairing policies to be applied during BOP Imbalances:
Exchange Rate Adjustments and Elasticity Approach
Exchange rate determination takes place through supply and demand forces of free markets in floating exchange rate systems. There is little or no government intervention in markets to rule the rates. When there is a deficit in BOP, then excess supply of domestic currency will appear in the markets and exchange rates will tend to increase (domestic currencies depreciate). Then foreign goods and services will be more expensive and import volume will tend to decrease. And exports will tend to increase since domestic production will be cheaper in foreign markets. And foreign exchange receipts will increase. This mechanism will work until there is equilibrium in the market. In case of a surplus in BOP, then the mechanism will work in reverse direction. This mechanism is most commonly related with current account balance of BOP.
There is no application with pure floating system in real life in which there is no government intervention. So some countries have adopted fixed exchange rate system and/or fixed and free floating system combinely in which they peg their currencies to a single foreign currency or a basket of foreign currencies (SDR or others). Since the governments of these countries allow a limited floating around other currencies, this system is commonly known as “managed float system” (like in Turkey). Again exchange rate adjustment is one of the important tools to be applied by those countries. When there is a deficit in BOP, the monetary authorities will tend to devalue their currency against foreign currencies. Consequently, exports will tend to increase and imports will tend to decrease in those countries.
Elasticity Approach
BOP effects of exchange rate fluctuations are generally explained by Elasticity Approach. When there is a devaluation (in fixed rate systems) or depreciation (in floating rate systems) in domestic currency, then exports are likely to increase and imports are likely to decrease. The positive effects of devaluation depends on price elasticity of export demand. The higher the price elasticity of foreign demand for exports and domestic demand for imports, the more the effects of devaluation will be. This theoretical relationship was previously explained by Marshall-Lerner by the following formula:
Ex + Em ³ 1Where Ex represents the foreign demand elasticity for exported goods/services and Em represents domestic demand elasticity for imported goods/services. According to this approach, in the case of lower elasticities for exported and imported goods/services devaluation will not be effective. It may even affect BOP negatively. However, the new studies have shown that these elasticity coefficients are enough high to have the positive effects of devaluation.
Exchange rate determination takes place through supply and demand forces of free markets in floating exchange rate systems. There is little or no government intervention in markets to rule the rates. When there is a deficit in BOP, then excess supply of domestic currency will appear in the markets and exchange rates will tend to increase (domestic currencies depreciate). Then foreign goods and services will be more expensive and import volume will tend to decrease. And exports will tend to increase since domestic production will be cheaper in foreign markets. And foreign exchange receipts will increase. This mechanism will work until there is equilibrium in the market. In case of a surplus in BOP, then the mechanism will work in reverse direction. This mechanism is most commonly related with current account balance of BOP.
There is no application with pure floating system in real life in which there is no government intervention. So some countries have adopted fixed exchange rate system and/or fixed and free floating system combinely in which they peg their currencies to a single foreign currency or a basket of foreign currencies (SDR or others). Since the governments of these countries allow a limited floating around other currencies, this system is commonly known as “managed float system” (like in Turkey). Again exchange rate adjustment is one of the important tools to be applied by those countries. When there is a deficit in BOP, the monetary authorities will tend to devalue their currency against foreign currencies. Consequently, exports will tend to increase and imports will tend to decrease in those countries.
Elasticity Approach
BOP effects of exchange rate fluctuations are generally explained by Elasticity Approach. When there is a devaluation (in fixed rate systems) or depreciation (in floating rate systems) in domestic currency, then exports are likely to increase and imports are likely to decrease. The positive effects of devaluation depends on price elasticity of export demand. The higher the price elasticity of foreign demand for exports and domestic demand for imports, the more the effects of devaluation will be. This theoretical relationship was previously explained by Marshall-Lerner by the following formula:
Ex + Em ³ 1Where Ex represents the foreign demand elasticity for exported goods/services and Em represents domestic demand elasticity for imported goods/services. According to this approach, in the case of lower elasticities for exported and imported goods/services devaluation will not be effective. It may even affect BOP negatively. However, the new studies have shown that these elasticity coefficients are enough high to have the positive effects of devaluation.