Understanding World Currencies

and Exchange Rates

Contents
Currencies
Exchange Rates
Exchange Rate Movements
Interpreting Numerical Exchange Rate Movements
How Foreign Exchange Markets Work
Why Exchange Rates Move
Government Manipulation of Exchange Rates
Euro
Currency Crises / Collapses
Links to Web Sites on Topic
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 Currencies
• For reasons of “part of being a country” and
being able to control/influence an important
part of the domestic economy, most countries
have their own money
• When spoken of in the domestic context, this
money is referred to as the money supply;
when this money supply is traded with other
money supplies internationally, the term
currency is more often used

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 Exchange Rates
• The rates at which these currencies exchange with
other currencies are known as foreign exchange rates,
or the short hand of exchange rates
• The most important exchange rates for currencies are
the exchange rates with the US$. In fact this is almost
the only exchange rate actually used in actual foreign
exchange trading, as the foreign exchange trading
process does not typically trade non-$ currencies
directly with each other, instead trading the first into
dollars and then from dollars into the second.

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 Exchange Rates
• While paling in importance to the exchange rates
between US$ and other world currencies, a second
exchange rate that is calculated for analysis
purposes are so called cross exchange rates, the
implicit rate between 2 non-$ currencies.
• These rates are often used to track competitiveness
between 2 non-US countries. Examples of
important rate pairs in this regard are: Pound/Euro,
Yen/SKWon, Yen/Yuan, Peso/Real, Florint/Zloty,
Indian Rupee / Pakistan Rupee
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 Exchange Rates
• A final exchange rate that is used for analysis
purposes is a calculated average value, or
exchange rate, of one currency against an
average of other important currencies. These
exchange rates go by various names – average,
effective, trade-weighted, etc. – and have as
purpose tracking a countries’ overall exchange
rate competitiveness against a basket of
important world currencies.
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 Exchange Rate Movements
• As we all know, currencies move in value
against each other, or, their exchange rates
change
• Essentially, other than not changing, there are
2 movements
– A currency can rise in value against another
currency / other currencies
– A currency can fall in value against another
currency / other currencies
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 Exchange Rate Movements
• When the movement is a rise in value, the
currency or exchange rate is said to have
appreciated against the other currency(ies) …..as
in the “Dollar appreciated against the Yen”
• When the movement is a fall in value, the
currency or exchange rate is said to have
depreciated against the other currency(ies) …..as
in the “Peso depreciated against the Dollar”

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 Interpreting Numerical
Exchange Rate Movements
• So we know that exchange rates appreciate
and depreciate, but to know how to decide if a
particular numerical exchange rate movement
is appreciation or depreciation requires
another, not trivial step
• The reason the step is non-trivial is that by
foreign exchange trading community
conventions, not all exchange rates are
expressed same way

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 Interpreting Numerical
Exchange Rate Movements
• In particular, there are 2 ways that the most
important exchange rates, those with US$, are
expressed
– For nearly all world currencies, the exchange rate
is expressed as Numbers of Foreign Currency per
US$, as Yen100/$, Mexican Pesos12/$, Indonesian
Rupiahs9000/$, Canadian Dollars 1.04/$, etc.
– But, for 2 world currencies, the Pound and the
Euro, the convention is Numbers of $ per Pound
or Euro, as in $1.56/Pound and $1.29/Euro

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 Interpreting Numerical
Exchange Rate Movements
• So, and not surprisingly, what is appreciation or
depreciation differs for the 2 forms of the exchange
rates with dollar.
– For the Numbers of Foreign Currency per Dollar exchange
rates – most exchange rates – when the numerical exchange
rate goes up, it means the $ has appreciated and the foreign
currency depreciated, with the opposite meaning for the
numerical rate going down
• So when Japanese Yen / Dollar rate goes from 90 to 100 per Dollar,
it means Yen has depreciated and Dollar has appreciated – from
dollar perspective, I get more Yen for a Dollar – Dollar is of greater
value
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 Interpreting Numerical
Exchange Rate Movements
– For the Numbers of Dollars per Foreign Currency
exchange rates– Pound and Euro– when the
numerical exchange rate goes up, it means the $
has depreciated and the foreign currency
appreciated, with the opposite meaning for the
numerical rate going down
• So when US$ / Euro rate goes from 1.32 to 1.20, it
means Dollar has appreciated and Euro depreciated –
from dollar perspective, it takes fewer Dollars to buy a
Euro – Dollar is of greater value (and my European trip
is cheaper)

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 Interpreting Numerical
Exchange Rate Movements
• For cross exchange the same principles apply; when a cross
exchange rate goes up/down numerically, it means the
currency in numerator of expression has depreciated/
appreciated and the currency in denominator of expression
has appreciated/depreciated
– So, if SKWon/JapanYen rate goes from 10 to 8, would mean won
had appreciated, yen had depreciated
• For average exchange rates, they are always set up such that
a higher/lower numerical average exchange rate means on
average appreciation/depreciation against other major
currencies
– So if the average exchange rate index value for British pound
went from 101 to 105, would mean pound had appreciated

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 How Currency Markets Operate
• While we will soon plan to get to what makes
exchange rates move – appreciate or depreciate,
it will be useful to discuss the mechanics of how
currency markets work
• Currency markets are “run” by foreign exchange
departments of international banks, and
specialty foreign exchange trading firms
• These departments and firms acts as brokers /
dealers / intermediaries between the ultimate
users of foreign trade exchange
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 How Currency Markets Operate
• These ultimate users of foreign exchange are entities
who have operations in more than one currency /
country; they need to trade currencies to move their
resources from one country to another.
• Examples of these entities include: exporters and
importers, governments, international investors,
currency speculators, multinational companies, etc.
• Each of them frequently or occasionally need to
convert value in one currency into value in another
currency.
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 How Currency Markets Operate
• To carry out the needed exchange, they will go the foreign
exchange trading community and make an “offer” of the
currency they have and a “bid” for the currency they want,
at the price or exchange rate being quoted by the foreign
exchange trading community.
• Because so much foreign exchange trading is going on –
some say as much as $5 trillion a day – it will be almost
certain that someone else will be “offering” the currency
they want and “bidding” for the currency they have, and
the exchange is quickly completed.
• The foreign exchange traders make their money by profiting
from small gaps between the bid and offer prices for the
currency.

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 How Currency Markets Operate
• This trading of currencies goes on in two types of
foreign exchange markets.
– In the spot market, the one most familiar, the
exchange of currencies is made instantly, or, to be
exact, settled within 2 days.
– In the forward market, in some ways the one most
important, the contract to exchange the currencies,
including the amount and the exchange rate, is made
today, but the actual exchange does not occur until a
date well into the future specified in the contract.
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 How Currency Markets Operate
• The forward contract is so important because it
allows international economic actors to either hedge
currency exposure or speculate in currencies, both
important activities.
• Hedgers, especially exporters and importers, use the
forward foreign exchange market to “lock in” an
exchange rate at which they can exchange a receipt
from or payment to another currency due at some
future date, eliminating risk of currency movement.
Without the forward foreign exchange market,
international trade would cease.
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 How Currency Markets Operate
• Speculators use the forward market to make “bets”
on the future movements of currencies more
efficiently than if they had to actually had to buy or
sell the currency they thought was going to
appreciate or depreciate, respectively.
– A particularly notable currency speculator who makes
great use of the forward market is George Soros
• The major centers of currency trading in the world
are in 3 cities, London, New York, and Tokyo, but
with the growing importance of China’s economy,
Shanghai may get added to the list in 10 years or so.
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 Why Exchange Rates Move
• While it is very difficult to explain exactly why a
specific currency moves a specific direction on a
specific day, the basic forces are straightforward.
– Essentially, a currency rises in value, or appreciates, when
there is more money trying to get into the country to buy
its goods or invest in it, or, less money trying to leave the
country to buy foreign goods or invest somewhere else.
– A currency falls in value, or depreciates, when there is less
money trying to get into the country to buy its goods or
invest in it, or, more money trying to leave the country to
buy foreign goods or invest somewhere else.

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 Why Exchange Rates Move
Exch Supply of Domestic Currency
Rate Leaving Country
This graph is a useful way to illustrate
Movement of exchange rates.
App -- The Supply Curve shows amount of monies
wanting to leave country. If they increase
appreciates Supply Curve shifts to right and causes currency
Initial to depreciate, and vice versa.
Exch Rate -- The Demand Curve shows amount of monies
depreciates
wanting to enter country. If they increase
Dep Demand Curve shifts to right and currency
Appreciates and vice versa.

Demand for Domestic

Currency To Get Into Country

Domestic Currency Being Traded on FX Markets

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 Why Exchange Rates Move
• There are variety of forces that drive whether
more/less money flows into / out of a country.
– Stability relative to other countries, with relatively
more/less internal stability causing money to
enter/leave.
– Inflation relative to other countries, with relatively
more/less internal inflation causing money to
leave/enter.
– Productive capabilities relative to other countries,
with relatively more/less internal productive
capability causing money to enter/leave.
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 Why Exchange Rates Move
– Economic policies relative to other countries, with
relatively better/poorer internal economic policies
causing money to enter/leave.
– Interest Rates relative to other countries, with
relatively higher/lower internal interest rates
causing money to enter/leave.
– Rates of domestic spending relative to other
countries, with relatively more/less internal
domestic spending causing money to enter/leave.

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 Why Exchange Rates Move
• Examples
– Over past 8-9 months, yen has depreciated against the
dollar, moving from 85 to dollar to 100 to dollar, as a result
of the Japanese government increasing domestic spending
and lower interest rates, causing on balance less money to
enter Japan and more to leave
– Over the past several years, the China exchange rate has
appreciated against the dollar, going from 8.32 to 6.32 per
dollar, as a result of China being a great place from which
to export goods and in which to invest, causing large
amounts of money to want to enter China. (Of course, as
to be discussed next, China’s government has prevented
the appreciation as much it could have been through
currency manipulation)

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 Why Exchange Rates Move
• It also is important to look at what happens when
exchange rates do move. Essentially:
– When an exchange rate appreciates,
• It makes the country more expensive to the rest of the world
and the rest of the world less expensive to the country
• Increases money going out and lowers money coming in
• Helps importers and consumers and hurts exporters
– When an exchange rate depreciates,
• It makes the country less expensive to the rest of the world
and the rest of the world more expensive to the country
• Lowers money going out and raises money coming in
• Helps exporters and hurts consumers and importers
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 Government Manipulation of
Exchange Rates
• Governments can and do chose from a variety of
ways to manage their currencies and exchange
rates.
• The IMF provides the following categories of these
ways:
– Pure float – government has no “correct” exchange rate
and takes no action to affect exchange rate (US Dollar)
– Managed float – government has no correct exchange
rate but does on occasion take actions to affect speed
of exchange rate movements (Japan Yen)
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 Government Manipulation of
Exchange Rates
– Peg – government chooses and announces a desired
exchange rate, and when necessary takes actions to
keep that rate (Saudi Arabia Rial)
– Crawling Peg – government chooses, not a specific
exchange rate, but a pace of change in the rate, and
when necessary takes actions to keep that pace of
change (no used much anymore; Turkey a historical
example)

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 Government Manipulation of
Exchange Rates
– Currency Board – like a peg, except the government
takes away from itself the ability to change the rate or
take actions to hold or not hold it (Hong Kong, Estonia,
Bulgaria)
– Use Some Other Country’s Currency, sometimes called
dollarization – formally declares the money to be used
in the country is some other currency (Panama, El
Salvador, Ecuador, and the Euro)

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 Government Manipulation of
Exchange Rates
• What the government and central bank have to do in
case of floating exchange rate is simple – very little – as
they allow the market to set the rate.
• In the case of a peg, however, a process must be
followed
– First, a currency, or group of currencies, that is to be pegged
against must be chosen
– Second, the desired rate must be set and announced
– Third, the amount the actual rate will be allowed to deviate
from the desired rate, called flucuation bands, must be set
– Fourth, then actual exchange rate reaches upper or lower
flucuation bands, actions, called intervention must be taken28
 Government Manipulation of
Exchange Rates
• The nature of intervention is as follows.
– If the actual exchange rate is trying to rise in value / appreciate,
the central bank will use its domestic money supply to buy up
foreign exchange to keep exchange rate from appreciating. This
is called undervaluing exchange rate
– As a result, the exchange rate will not appreciate and the central
bank will accumulate foreign exchange rate reserves; China is
best example of this.
– The primary reason for doing this is to maintain export
competitiveness
– As the country has unlimited supply of its own money, this action
can be carried out indefinitely

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 Government Manipulation of
Exchange Rates
– If the actual exchange rate is trying to fall in value /
depreciate, the central bank will use its foreign exchange
reserves to buy up domestic currency to keep exchange rate
from depreciating. This is called overvaluing exchange rate
– As a result, the exchange rate will not depreciate but the
central bank will lose foreign exchange rate reserves;
countries that eventually have a currency crisis – Mexico,
East Asia, etc. are best examples of this.
– The primary reason for doing this is to provide stability of
exchange rate (often backfires) and political purposes
– As the country does not have unlimited supply of foreign
exchange reserves, this action generally leads to problems

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 Euro
• Over the course of the 1990s and early part of last decade,
a sub-set of the EU countries created a common currency
known as the Euro
• The purpose of the Euro was to reduce foreign exchange
costs of trading within the EU and to create a competitor
currency to the dollar
• The steps to creating, and now expanding, Euro are:
– Before joining, match economic polices, especially money
supply, inflation, budget balances
– Decide on the exchange rate that will be used to go into the
Euro
– Join and replace the original national currency with the Euro –
in effect dollarize with the Euro
– Give up the ability to use changes in domestic money supply
and changes in exchange rate as tools to solve economic
problems
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 Euro
• While the Euro has in general benefitted the member countries, it
also, because of the nature of what it entailed, was a major part of
the cause and difficulty in solving the ongoing European financial
crisis, as follows.
– On the Cause side, when countries were allowed into Euro, a perception
was created that they had good economic policies, so countries like
Greece, Italy, etc., could borrow money as easily as Germany
– But, as we have seen, these countries did not have good economic
policies, so they were allowed to overborrow
– When the overborrowing was realized, huge amounts of money left,
collapsing their economies
– On the Solution side, if Greece, Italy, etc. were not in Euro, they could
have expanded their domestic currency and/or depreciated their
exchange rate as means of reducing the collapse, but, since they were in
Euro, could not
– And so, the crisis has lingered and lingered and……..

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 Currency Collapse
• Our final topic, and a useful comparison to Euro
crisis, is currency collapse
• A currency collapse is defined a large, rapid
depreciation of a country’s exchange rate, say 30-
40% or more in less than 2-3 months
• Examples include: Mexico in 1994, East Asia in
1997, Russia in 1998, Turkey in 2001, Argentina in
2002, Iceland in 2008, to cite a few

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 Currency Collapse
• A currency collapse generally follows following
pattern.
– Country has a pegged exchange rate
– Because of good economic policies / circumstances,
foreign money is flowing in
– Policies / circumstances turn negative (instability, excess
inflation, business-unfriendly policies )
– Foreign money flows reverse
– Downward (depreciation) pressure is placed on
exchange rate
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 Currency Collapse
– Central bank, because of peg, “defends” the exchange rate by
buying local currency (that the foreign investors are selling to
get out) with foreign exchange reserves
– Exchange rate remains same, but reserves fall
– Reserves eventually near zero, the central bank has to stop
intervening, and the currency collapses leading also to a
fairly severe domestic economic recession
– The IMF comes in and assists the country to stabilize the
currency, albeit at a much lower level
– The presence of the IMF, the lower value for the currency
and its impact on competitiveness, and better circumstances
and policies, the latter that the IMF demands, arrest the
economic deterioration and put the economy back on an
upward trend
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 Links to Websites
• Foreign Exchange Market
• http://en.wikipedia.org/wiki/Foreign_exchange_m
arket
• Exchange Rates
• http://en.wikipedia.org/wiki/Exchange_rate

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