3.7 Currency Exchange Rates - 3.7 Currency Exchange Rates Explained

Key Concepts

• Spot Exchange Rate
• Forward Exchange Rate
• Cross-Currency Rates
• Exchange Rate Determination
• Arbitrage

Spot Exchange Rate

The spot exchange rate is the current market rate at which one currency can be exchanged for another. It is the rate used for immediate transactions, typically settled within two business days.

Example: If the spot exchange rate for USD/EUR is 0.85, it means you can exchange 1 US Dollar for 0.85 Euros.

Forward Exchange Rate

The forward exchange rate is the rate at which a currency can be exchanged at a future date, agreed upon today. It is used to hedge against currency risk and is determined by the spot rate adjusted for interest rate differentials between the two currencies.

Example: If the spot rate for USD/EUR is 0.85 and the interest rate in the US is higher than in the Eurozone, the forward rate for USD/EUR in 3 months might be 0.84 to account for the interest rate advantage.

Cross-Currency Rates

Cross-currency rates are exchange rates between two currencies that are not the US Dollar. These rates are derived from the exchange rates of the two currencies against a common third currency, usually the US Dollar.

Example: If the USD/EUR rate is 0.85 and the USD/GBP rate is 0.75, the EUR/GBP cross-rate can be calculated as 0.85 / 0.75 = 1.1333.

Exchange Rate Determination

Exchange rates are determined by the interaction of supply and demand in the foreign exchange market. Factors influencing exchange rates include interest rates, inflation rates, economic growth, political stability, and central bank interventions.

Example: If the Federal Reserve raises interest rates in the US, the demand for USD increases, leading to an appreciation of the USD against other currencies.

Arbitrage

Arbitrage is the practice of taking advantage of a price difference between two or more markets. In the context of currency exchange, arbitrage involves buying a currency in one market and selling it in another to make a profit from the price discrepancy.

Example: If the USD/EUR rate is 0.85 in New York and 0.86 in London, an arbitrageur could buy USD in New York and sell it in London, profiting from the 0.01 difference.