Exchange rates and currency markets
When businesses and investors cross borders, they must exchange currencies. Exchange rates add both opportunities and risks.
The foreign exchange market
The foreign exchange (forex) market is the world's largest financial market, with average daily turnover of about 9.6 trillion dollars in April 2025, according to the Bank for International Settlements' triennial survey. It operates around the clock through banks and electronic platforms; the US dollar is on one side of almost 90% of trades.
Quoting exchange rates
An exchange rate is the price of one currency in terms of another. A direct quote gives the home-currency price of one unit of foreign currency (for an American, 1 euro = 1.10 dollars); an indirect quote gives foreign currency per unit of home currency (1 dollar = 0.91 euros). A cross rate is an exchange rate between two currencies calculated through a third, usually the dollar.
Spot and forward rates
The spot rate is the price for immediate exchange (settled within about two business days). A forward rate is agreed today for exchange at a future date. Forward contracts let businesses lock in rates; if the forward rate is above the spot rate, the currency trades at a forward premium, otherwise at a discount.
Appreciation and depreciation
A currency appreciates when it buys more of another currency and depreciates when it buys less. A stronger home currency makes imports cheaper and exports more expensive for foreign buyers; a weaker currency does the reverse, helping exporters but raising import costs and inflation.
Purchasing power parity
Purchasing power parity (PPP) suggests that exchange rates adjust so identical goods cost the same across countries. Relative PPP predicts that currencies of high-inflation countries depreciate. PPP holds poorly in the short run but helps explain long-run trends. The Economist's Big Mac index is a light-hearted PPP comparison.
Interest rate parity
Covered interest rate parity says the forward premium or discount reflects interest rate differences: \(\frac{F}{S} = \frac{1 + i_{home}}{1 + i_{foreign}}\). If home interest rates are higher than foreign rates, the foreign currency trades at a forward premium. Otherwise, investors could earn risk-free arbitrage profits.
What moves exchange rates
Exchange rates respond to interest rate differences, inflation, economic growth, trade balances, political stability, central bank interventions, and market sentiment. Higher interest rates tend to attract capital and strengthen a currency in the short run. Safe-haven currencies, such as the US dollar and Swiss franc, often strengthen in crises.
Worked example
An American company will receive 1 million euros in six months. The spot rate is 1.10 dollars per euro, and the six-month forward rate is 1.11. By selling euros forward, the company locks in 1.11 million dollars. If the euro instead falls to 1.05 in six months, the hedge protects it from receiving only 1.05 million dollars.
Key takeaways
The forex market is the world's largest, with about 9.6 trillion dollars of daily turnover in 2025. Exchange rates can be direct, indirect, or cross rates. Spot rates are for immediate exchange; forward rates lock in future exchange. Appreciation makes imports cheaper and exports dearer. PPP explains long-run trends; interest rate parity links forward rates to interest differences. Exchange rates respond to interest rates, inflation, growth, politics, and sentiment.
Flashcard
Largest financial market
Check your understanding
A US exporter will receive euros in three months and fears the euro will weaken. What can it do?