LESSON TWO: EXCHANGE RATES
By DR.STEPHEN ODHIAMBO
At the end of this topic the learner should be able to describe:
a) The meaning of the term exchange rates and the factors affecting exchange rates
b) The functions and participants of the foreign exchange markets
c) The various exchange rate regimes
c) Concept of currency exposures
d) Types of Currency Markets
e) Concept of Bid & Ask as used in foreign exchange market
1.1 What is an Exchange rate?
An exchange rate is the rate at which one currency can be exchanged for another. In other words,
it is the value of another country's currency compared to that of your own. If you are traveling to
another country, you need to "buy" the local currency. Just like the price of any asset, the
exchange rate is the price at which you can buy that currency. If you are traveling to Turkey, for
example, and the exchange rate for a Turkish lira is Ksh.20, this means that for every Ksh. 20
you can buy one Turkish Lira.
Foreign exchange (forex or FX for short) is one of the most exciting, fast-paced markets around
the world. Until recently, trading in the forex market had been the domain of large financial
institutions, corporations, central banks, hedge funds and extremely wealthy individuals. The
emergence of the Internet has changed all of this, and now it is possible for average investors to
buy and sell currencies easily with the click of a mouse.
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, The foreign exchange market is the "place" where currencies are traded. Currencies are important
to most people around the world, whether they realize it or not, because currencies need to be
exchanged in order to conduct foreign trade.
As you know, money is anything that is accepted as a medium of exchange. In most of the world,
people accept pieces of paper imprinted with pictures of national heroes or local wonders of
nature as money. But in each nation, they accept different pieces of paper
This means that if someone in the United States wants to buy something from someone in, say,
Tanzania, he/she must first exchange his/her local currency—dollars—for the currency accepted
in Tanzania —shillings. This currency conversion occurs at an exchange rate market.
The exchange rate—the price of one nation's currency in terms of another nation's—is a central
concept in international finance. Virtually any nation's currency can be converted into the
currency of any other nation, thanks to exchange rates and the foreign exchange market. For
instance, let's say the current exchange rate between the U.S. dollar and the Tanzanian shillings is
$1 to 1000 sh. This means that $1 will buy 1000 shs and that 1000 shs will buy $1. (I am
ignoring transaction costs, such as the commission charged by the bank or foreign exchange
broker who does the currency conversion.)
1.2 Functions of the Foreign Exchange Market
The main functions of foreign exchange market are: -
a) Transfer of purchasing power
b) Provision of credit
c) Minimization of foreign exchange risk.
a) Transfer of Purchasing Power
Transfer of purchasing power is necessary because international trade and capital transactions
normally involves parties living in countries with different national currencies. Each part usually
wants to deal in its own currency, but the trade or capital transaction can be invoiced in only one
single currency.
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By DR.STEPHEN ODHIAMBO
At the end of this topic the learner should be able to describe:
a) The meaning of the term exchange rates and the factors affecting exchange rates
b) The functions and participants of the foreign exchange markets
c) The various exchange rate regimes
c) Concept of currency exposures
d) Types of Currency Markets
e) Concept of Bid & Ask as used in foreign exchange market
1.1 What is an Exchange rate?
An exchange rate is the rate at which one currency can be exchanged for another. In other words,
it is the value of another country's currency compared to that of your own. If you are traveling to
another country, you need to "buy" the local currency. Just like the price of any asset, the
exchange rate is the price at which you can buy that currency. If you are traveling to Turkey, for
example, and the exchange rate for a Turkish lira is Ksh.20, this means that for every Ksh. 20
you can buy one Turkish Lira.
Foreign exchange (forex or FX for short) is one of the most exciting, fast-paced markets around
the world. Until recently, trading in the forex market had been the domain of large financial
institutions, corporations, central banks, hedge funds and extremely wealthy individuals. The
emergence of the Internet has changed all of this, and now it is possible for average investors to
buy and sell currencies easily with the click of a mouse.
1
, The foreign exchange market is the "place" where currencies are traded. Currencies are important
to most people around the world, whether they realize it or not, because currencies need to be
exchanged in order to conduct foreign trade.
As you know, money is anything that is accepted as a medium of exchange. In most of the world,
people accept pieces of paper imprinted with pictures of national heroes or local wonders of
nature as money. But in each nation, they accept different pieces of paper
This means that if someone in the United States wants to buy something from someone in, say,
Tanzania, he/she must first exchange his/her local currency—dollars—for the currency accepted
in Tanzania —shillings. This currency conversion occurs at an exchange rate market.
The exchange rate—the price of one nation's currency in terms of another nation's—is a central
concept in international finance. Virtually any nation's currency can be converted into the
currency of any other nation, thanks to exchange rates and the foreign exchange market. For
instance, let's say the current exchange rate between the U.S. dollar and the Tanzanian shillings is
$1 to 1000 sh. This means that $1 will buy 1000 shs and that 1000 shs will buy $1. (I am
ignoring transaction costs, such as the commission charged by the bank or foreign exchange
broker who does the currency conversion.)
1.2 Functions of the Foreign Exchange Market
The main functions of foreign exchange market are: -
a) Transfer of purchasing power
b) Provision of credit
c) Minimization of foreign exchange risk.
a) Transfer of Purchasing Power
Transfer of purchasing power is necessary because international trade and capital transactions
normally involves parties living in countries with different national currencies. Each part usually
wants to deal in its own currency, but the trade or capital transaction can be invoiced in only one
single currency.
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