Some Exchange Rate Related Concepts

By Author: Abey Francis
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Exchange rate in a floating rate system is determined by the demand and supply forces. The higher the demand or lower the supply, the greater the value of the currency in the spot foreign exchange market. There are different theories explaining the exchange rate behavior. While the balance of payments theory stresses on the current account and the capital account behavior influencing the exchange rate, the monetary theories emphasize on the demand and supply of money being the main force behind exchange rate behavior. Some forecasters believe that for the major floating currencies, foreign exchange markets are “efficient” and forward exchange rates are unbiased predictors of future spot exchange rates. The asset approach to forecasting suggests that whether foreigners are willing to hold claims in monetary form depends partly on relative real interest rates and partly on a country’s outlook for economic growth and profitability. The factors influencing the exchange rate are primarily the inflation rate and interest rate differentials. In the forward market it is the Interest Rate Parity theory that explains exchange rate ...
... determination.

Some important terms used in foreign exchange systems are:

Balance of Payments: A financial statement summarizing the flow of goods, services, and investment funds between residents of a given country and residents of the rest of the world.

Capital account: A section of the balance of payments accounts. Under the revised format of the IMF, the capital account measures capital transfers and the acquisition and disposal of non-produced and non-financial assets.

Covering: A transaction in the forward foreign exchange market or money market which protects the value of future cash flows.

Current account: In the balance of payments, the net flow of goods, services, and unilateral transfers such as gifts between a country and all foreign countries.

Devaluation: A drop in the spot foreign exchange value of a currency that is pegged to other currencies or to gold.

Flexible exchange rates: The opposite of fixed exchange rate is adjusted periodically by the country’s monetary authorities in accordance with their judgement and/or an external set of economic indicators.

Floating Exchange rates: Foreign exchange rates determined by demand and supply in an open market that is presumably free of government interference.

Revaluation: A rise in the foreign exchange value of a currency that is pegged to other currencies or gold. Also called “appreciation”.