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Exchange Rates: Get the Facts Right

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Did you know that exchange rates could actually affect the price at which you buy something? If you have Japanese currency, are located in the US and want to buy something worth 1 USD you would need to shell out 123 Yen (Wikipedia 2007 [online]). It is estimated that foreign exchange rates market are one of the biggest in the world. Almost 2 trillion dollars worth of money gets exchanged every single day! Unbelievable, right?

 

Demystifying the jargons

If you have always been perplexed and confused as to all the complex jargons that surround the world of exchange rates, fear not. Here we help you understand some of the common terms used:

-          The spot exchange rate: This refers to the existing exchange rates as per market conditions

-          Forward exchange rates: This is the rate that gets quoted and traded in on the current date. However, the delivery and ultimate payment will be made sometime in the future.

-          Free exchange rate regimes: In this scenario the currency is usually free floating, which means it is constantly changing. In these cases the exchange rates can freely change as determined by market conditions of demand and supply. It maybe very difficult to keep track of such exchange rates as they keep fluctuating very rapidly.

-          Pegged exchange rates: This is a type of fixed exchange rate where the rate is determined at a certain level. However there maybe a margin set aside to accommodate any devaluation or undervalue in currency. During the period from 1994 till 2005, Chinese exchange rates were pegged at a certain limit range.

-          Nominal rates: These kinds of exchange rates are the prices of the domestic currency in terms of one unit of a foreign currency. For example at present 234.975 Japanese Yen make up 1 unit of British Pound.

-          Real exchange rates: Also known as RER, this rate is defined by the equation – e(P*/P) where P refers to the domestic price value and P* refers to the foreign price value. The value of e is the current base year (since both the foreign value and domestic exchange rates must be evaluated on the same year).

-          Interest rate parity: The short form for it is the IRP. It basically means that if the exchange rates for one country go up or down as compared to another country, then the value of the currency needs to change to avoid a situation of arbitrage. So let’s say the USD interest rate goes up higher compared to the Japanese Yen currency, the value of the USD needs to fall below the Yen to prevent arbitrage in exchange rates (Wikipedia 2007 [online]).

 

So what’s arbitrage?

If the term gives an impression of soldiers up in arms, rest assured it’s not so. Arbitrage is a situation where unscrupulous forces (called arbitrageurs) take undue advantage of the imbalance in currency values and exchange rates between two countries. The ultimate objective of such elements is to make the maximum profit out of highly differing exchange rates without caring about the impact on the economy. What does that mean for the person? A completely risk free profit. The arbitrageur usually tries to make a neat profit from fluctuating exchange rates out of segments like shares, stocks, commodities as well as currencies. These areas are usually high risk in nature. So if the arbitrageur invests in such segments when the exchange rates are volatile, he or she can gain loads of profit – that too without any risk at all! Such arbitrageurs are usually risk neutral (Wikipedia 2007 [online]). They are individuals who assign the risk element irrespective of how much risk is predicted.

 

 

References:

Wikipedia )2007). Exchange Rate. Available from http://en.wikipedia.org/wiki/Exchange_rate. Last accessed 25 October 2007.

 

X-Rates (2007). Currency Calculator.  Available from http://www.x-rates.com/calculator.html. Last accessed 24 October 2007.

 

Wikipedia (2007). Arbitrage. Available from http://en.wikipedia.org/wiki/Arbitrage. Last accessed 26 October 2007.

 

Wikipedia (2007). Risk Neutral. Available from

http://en.wikipedia.org/wiki/Risk_neutral. Last accessed 25 October 2007.

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