How is the exchange rate worked out?

[Fassa Albrecht]

I'm sure a nice TBer can give me a simple explanation as to how currency exchange rates are worked out??

[BigKahuna13]

Originally Posted by Fassa Albrecht

I'm sure a nice TBer can give me a simple explanation as to how currency exchange rates are worked out??

The people who figure it out don't know. They just toss darts at a dartboard.


seriously i think it has to do with the balance of trade and relative purchasing power of each currency.

[Thunderscreech]

Originally Posted by BigKahuna13

The people who figure it out don't know. They just toss darts at a dartboard.

I think this is the preferred method. occasionally, they refer to the proper equations, but for the majority of the time they take tequila shooters and toss the darts.

[Fassa Albrecht]

Oh dear...does ANYONE actually know the real answer?

[fitbass3p]

It's based almost entirely on what people THINK the exchange rate should be. There's a healthy dose of supply and demand in there, but the majority of the price shifts are due to speculation on the part of investors.

[fitbass3p]

Originally Posted by BigKahuna13

seriously i think it has to do with the balance of trade and relative purchasing power of each currency.

There is also some truth in this statement

[shamrock&roll]

It's largely based on supply and demand within the trade markets with your home country as the standard base. For example, let's say an American buys 100 Newcastle United shirts from England. Obviously, the payment will be in USD, but USD is not the accepted payment in England so the English company will convert the USD into GBP, which will remove GBP from the trade market and put in USD in its place. The market price of USD will go down as a consequence and the price of GBP will raise because there is now more USD in the US-Great Britain trade market than GBP. Just with anything involving supply and demand, the more you have supply, the less demand there will be.

This works with the stock market as well. Take the sale of NUFC for example (I'm a Magpie fan...bad days for us). If the South African consortium purchases Mike Ashley's stock of the company, they will raise the money in South African rand and convert the rand into GBP. This will take GBP out of the market and put rand in, lowering the conversion rate of rand and increasing the conversion rate of GBP between Great Britain and South Africa.

It's all a regulated process though as countries have money in reserves that is not on the market yet to be able to balance out the market. The U.S. has the Federal Reserve, which controls the value of USD so I'll use that as an example. If the value of Japanese yen starts to go down, the Federal Reserve will buy yen with money from the reserves thus flooding the market with more USD and removing yen making the value of yen go up. Countries that are common trade partners will often do this to keep conversion rates evenly fixed to promote continued trade between the countries.

Central banks also play a large role as do investors. If a Central Bank feels it doesn't have enough GBP, it will buy pounds on the open market using other currency thus lowering the supply of GBP and increasing it's demand and therefore it's trade value. If an investor feels that the value of Chinese yuan will increase, they'll request more yuan for their product, which creates more demand for yuan.

Hope that helps a bit.

[jokn388]

haha yup my fault. I had two threads open at the wrong time and wrote in the wrong one. Fail

[IanStephenson]

You "buy" and "sell" money just like anything else.

When you order the 100 shirts (I grew up on tyneside), you ultimately end up with a price in $. That depends on the original price in pounds (which in turn depends on how much they cost in whatever financial system they were made in, and the value of the pound against that), and the price of the dollar against the pound.

If you decide that price is too high, then thats because (in part) that pounds are too expensive, so you don't buy the pounds to buy the shirts. The guy selling the pounds is left with a load of "surplus"(!!!) stock (pounds!) that isn't selling, so he has to drop the price, as he only MAKES money when he sells it to you.

If you think the shirts are cheap you'll buy more pounds to buy more shirts - the guy selling the pounds will realise that pounds are going like hot-cakes, and put the price up to make more money.

Ian

[Bruce Lindfield]

There is not one exchange rate - there are many - if you search around, you can find many different rates - safest is the "inter-bank rate" - but this is just set by the banks between themselves...?

[MakiSupaStar]

I don't know. My iphone tells me.

[EggyToast]

Originally Posted by Bruce Lindfield

There is not one exchange rate - there are many - if you search around, you can find many different rates - safest is the "inter-bank rate" - but this is just set by the banks between themselves...?

Banks don't set anything -- at least, not really. Banks are almost always reactionary, but they're also competing with other banks.

The exchange rate is, ultimately, not much different from a stock market. Who determines a stock price? The buyers of that stock. It's no different with currencies, although they're much more stable as they inherently have government backing.

So if you need to buy things in Euros, but you have USDollars, you need to sell Dollars and buy Euros. How do you estimate what a fair price is for that currency? Well, you try to evaluate the risk. How large is the country's GDP? How high are interest rates within the country? How accessible is credit? How much do goods & services cost in that country? All those elements factor into determining the exchange rate.

Now, that's for fiat currencies, or currencies that "float," and is typically reserved for strong, stable economies. Small economies or new economies typically "peg" their currency to a larger country's currency, such as the Euro or the Dollar, and then that's the exchange rate. While that will depress prices within the country, it serves to protect the economy from speculators who could, in theory, "buy everything" that's available for the country, forcing the country to do bad things to its own economy.

Of course, you'll note that currency prices are typically reflected in goods & services most transparently, as many things in the UK are essentially twice the numerical price as equivalent goods within the US. $45 jeans in the US cost $80-90 in the UK. If the exchange rate were to suddenly become equal, the price difference would largely evaporate, because it would otherwise be profitable to simply buy up the supply in one place and sell in the other and make a significant profit, without doing any actual work. This only exists on a small scale with the current global economy, due to trade restrictions and market limitations.