An exchange rate is a measure, often used in forex trading, of how much one currency is worth another. In forex trading, it serves as a means to indicate how different currencies are valued against each other. Also known as the spot exchange rate, it is often used to trade with currencies. In technical terms, it indicates the rate over which a currency usually moves. More often than not, this rate reflects the current rate in which it trades.
The exchange rate between two currencies reflects the country's total exports and imports. This is determined by data on trade flows and by national income estimates. It also reflects how well a country's fiscal policy is performing economically. In short, it reflects the country's demand for imported goods and its willingness to pay for its own exports.
In international forex trading, the exchange rate indicates whether a country's domestic currency is stronger or weaker compared to its foreign currency over time. On the other hand, the inflation rate shows how rapidly the price of domestic currency is rising or falling. As inflation rises, the central bank may increase the level of its domestic currency so that its value becomes higher over time. On the other hand, when the level of inflation declines, it may result to a decrease in domestic currency value.
In addition to indicators of inflation, a decline in the exchange rate between two countries may also indicate weaker demand for imported goods in that country. When the domestic currency makes it easier for imported goods to gain a foothold, more goods are sold. A lower demand for imported goods makes imported goods cheaper and allows exporters to make them cheaper.
Another thing that affects the real exchange rate is political stability. When a country is stable, there will be a lesser tendency for political instability to affect the trade. Also, when there is less change in government, the exchange rate between the two countries will also be adjusted. When there is more change in government, more fluctuations in the market basket may occur and this can cause a rapid deterioration in the real exchange rate of one country and an improvement in another country's real exchange rate.
The most common way of measuring market interest rates between two countries is to use the spot exchange rate between them and use the forward exchange rate to determine the difference between the two. However, this is only applicable if the two markets do not move radically. For instance, a market is usually very volatile when the interest rates are lowered because it lowers the cost of imported goods to the domestic market making imports cheaper. However, when the interest rate is raised, the imported goods will also become more expensive making it unviable for exporters to sell them. Therefore, it is only applicable when the Spot Forex rates are constantly in a range where the Spot Forex rate can be used as basis for the Forward Forex rate. With the use of the Forward Forex rate, the exchange rate between two currencies can be estimated but it is not regarded as being a true reflection of the exchange rate.
There are several instances that justify the use of the forward exchange rate. Two major examples are the periods when economic policies are undecided, which usually leads to a stable but fluctuating exchange rate. Another is when the two currencies are tied to a particular commodity such as oil wherein the prices are subject to changes depending on the increase or decrease in the oil production and consumption. Although most traders believe that this kind of analysis is a subjective evaluation, some commodity experts have proven that a Forex analysis based on the past trends of the exchange rate between two currencies gives rise to a more accurate forecast of the exchange rate changes.
In order for us to understand what exactly causes currency exchange rates to fluctuate, it is important for us to determine first the reasons why they change. The other major factors that can affect the exchange rates are the political stability of respective governments, the overall inflation of the country, and the level of domestic consumption. Political stability is believed to be the reason why a country has a stable but fluctuating currency because in times of crisis, there is an expectation that the political leaders will come up with a solution to the problem. Domestic inflation is attributed to the high levels of general consumer demand, while the increased level of international competition and the weakening of the U.S dollar are some of the factors that lead to the weakening of the U.S dollar.