Exchange Rate, a price at which one currency can be converted into another or into gold, Special Drawing Rights (SDRs), or another medium of international exchange. Exchange rates are essential for comparing economies and for trading purposes.
In trading, the spot price is the one that exists for immediate transactions. A forward price is one that is fixed between buyer and seller for a transaction that is to take place at a specified time in the future. Suppose an Australian company is buying machinery from Germany for a price of 1 million Euros, with payment to be made for delivery in three months’ time. By the time those three months are up, the Australian dollar-Euro exchange rate is likely to have changed. If the Australian dollar has depreciated in value by 5 percent, the cost of the machinery will have effectively increased by the same amount unless the company has protected itself from the uncertainties of shifts in exchange rates by taking out a forward-price currency contract when it agreed to the deal to buy the machinery. (In recent years it has become clear that some companies have been playing the forward currency markets for their own sake, incurring big losses on currency transactions instead of achieving the boost to profits they hoped for.)
There are a number of ways in which countries manage their exchange rates. When a currency is floating, its exchange rate is set by the market. The more in demand a currency is, the higher its price (exchange rate) will be. Sometimes a central bank will intervene in the market to help achieve a specific price level for its country’s currency; this is known as “dirty floating”. At the beginning of the 1990s, less than one-fifth of the world’s 150 or so main currencies were freely floating. By 1993, following the shake-up in the former Communist world, some 50 of the world’s currencies were freely floating.
When a currency is fixed, its exchange rate is pegged at a certain level, which may be raised (revalued) or lowered (devalued) from time to time. A fixed currency may, in fact, be fixed within a narrow band, as was the case under the agreement reached the Bretton Woods Conference that governed the exchange rates of all members of the International Monetary Fund (IMF) for almost three decades after World War II. Fixed currencies are usually fixed in relation to another currency (often the United States dollar) or to the IMF-introduced Special Drawing Right (SDR), or other baskets of currencies.
As exchange rates can fluctuate so rapidly, the World Bank developed the Atlas exchange method. The Atlas conversion factor for any year is the inflation-adjusted average of a country’s exchange rate for that year and the two preceding years.
Before the introduction of the single European currency, the Euro, most of the countries of the European Union had what might be called controlled-floating exchange rates as a result of their membership of the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS). Under the ERM each currency had a fixed rate against the European Currency Unit (ECU) from which cross-rates with other ERM-member currencies were calculated. Central banks were then required to keep their currencies within a specified percentage of all cross-rates. This was originally 2.25 percent for most countries and 6 per cent for a few, but in 1993, after the near collapse of the ERM, the upper limit was raised to 15 per cent. Britain and Italy withdrew from the ERM in 1992, after their currencies came under extreme pressure in the markets, although Italy subsequently rejoined in 1996.