Everything you need to know to understand currency rates

The exchange rate of a currency (the name of the currency accepted abroad) is the rate, that is, the price, of this currency against another currency. On financial news sites or specialized sites like Rates (http://rates.fm/) we can read, for example, USD/UAH = 37,370/36,870. The first price is the sale price of the first currency. The second price is the purchase price of the first currency.

Everything you need to know to understand currency rates

To be clear, USD/UAH = 37,370/36,870 means that one US dollar (USD) is sold for 37,370 hryvnias (UAH), and bought for 36,870 hryvnias. The convention is that these exchange rates are expressed in three decimal places.

And in this case, it is easy to distinguish between the sale price and the purchase price, remembering that the sale price is always lower than the purchase price. Depending on the commission held by the stockbroker, the difference between the selling and buying prices may be larger or smaller.

International currency designation

As you can see, each currency has its own name, be it the Canadian dollar or others. For simplicity and in order to establish an international standard that allows you to talk about all currencies wherever you are in the world without language barriers, each currency has a three-letter abbreviation. Often - but this is far from a general rule - the first two letters indicate the country, and the third refers to the name of the currency. For example, here is the abbreviation of the currencies of the USA, Canada, Great Britain, China, and Japan:

  • USD - US for the United States, D for a dollar;
  • GBP - GB for Great Britain, P for pound;
  • CNY - CN for China, Y for Yuan;
  • JPY - JP for Japan, Y for Yen.

Why do currencies have different values?

Finally, we cannot assess the value of a currency in absolute terms. That is why it is always expressed relative to another currency by an exchange rate, and by observing the variations of this rate over time. For example, you can see this when converting currency when paying by card, Visa cards are accepted in 200 countries. Each currency therefore has an exchange rate vis-à-vis each of the other currencies. The term bilateral exchange rate refers to the exchange ratio between two currencies and the effective exchange rate when considering all bilateral exchange rates. To establish it, each bilateral exchange rate is generally weighted by the share of the country's international trade in that currency.

Why are exchange rates important?

Exchange rates are of great importance for a country's economy, and in particular for its foreign trade.

For example, suppose that the hryvnia, cash flow is 688 billion hryvnias, appreciates against the dollar, i.e. the exchange rate of the hryvnia against the dollar increases from 1 UAH =36,3 USD to 1 UAH =36,7 USD a few months later.

As for goods and services, the products exported by the United States to Ukraine will be more competitive. Example: 1 unit of the product "made in the USA" worth 20 USD cost 726 UAH in Ukraine (20 USD * 36.3 UAH). In a few months, it will cost  734 UAH ( 20 USD *  36.7 UAH). Conversely, products exported from Ukraine will have a higher price in US dollars and will be less competitive in the United States compared to local products.

But if there is not enough domestic production to avoid additional imports – which can be the case for energy or raw materials, often from developing countries – this can be a factor in inflation in a country whose exchange rate is depreciating.

Finally, at the individual level, with the growth of the hryvnia/dollar exchange rate, Ukrainian tourists will have reduced purchasing power in the US, and, conversely, the stay of American tourists in Ukraine will be cheaper for them. When it comes to investments and investments, US assets are worth more to Ukrainian investors and Ukrainian assets are worth less to US investors, so a fall in the hryvnia could logically favor investment in Ukraine.

Is an equilibrium exchange rate possible?

Balanced exchange rates, neither overvalued nor undervalued, would, in principle, correspond to the situation of internal and external balance of different economies. However, determining equilibrium exchange rates is not an exact science, and it is difficult to assess currency undervaluation (or overvaluation). As a rule, the purchasing power parity method is used to estimate what the equilibrium exchange rate should be, that is, the exchange rate that should balance the price of a basket of goods between two countries.

High volatility of the exchange rate

In fact, since floating exchange rate regimes have prevailed, i.e. for many years, equilibrium exchange rates have been very difficult to become a reality. On the contrary, exchange rate instability is the main feature of the modern world economy. So, for example, from 1999 to 2002, the dollar appreciated by 28.15% in relation to the hryvnia. Then, from 2002 to 2009, it rose in price by 47.2%. But exchange rate fluctuations of 5% or more during a month are not uncommon.

Therefore, stabilization of the exchange rate seems difficult. First, there is a diversity of regimes: although there has been a trend toward an expansion of the floating exchange rate regime since the 1990s, some currencies maintain a fixed exchange rate regime, and some central banks no longer hesitate to intervene to set an exchange rate favorable to their economies. Finally, it is clear that the currency market has become more speculative. Thus, certain fluctuations in the foreign exchange market do not necessarily correlate with the real state of the national economies of the respective currencies.

Therefore, it is important, especially for multinational corporations and banks that manage very large amounts of liquidity and are exposed to several currencies, to hedge against large exchange rate fluctuations. The foreign exchange market gives them access to various hedging instruments, such as futures transactions or more complex derivative products, such as swaps or options.