What is Foreign Exchange Rate and How is it Determined?
The foreign exchange rate is the rate at which one currency is converted to another. Mostly, the conversion rates for almost all currencies are constantly floating, driven by the supply and demand market forces. The US dollar is the key currency, accounting for more than 87% of the total daily value traded.
Several factors influence the market forces behind foreign exchange rates, including various economic, political, and even psychological conditions. Financial elements have government policies, trade balances, inflation, and economic growth.
Political conditions also impact the forex rate because events like political instability and political conflicts could negatively impact the value of a currency. In addition, the anticipation of forex market participants could also affect exchange rates.
The forex market is the largest (in terms of trade volume) and the most liquid in the world. The forex market’s major trading centers are located in major global financial hubs, which include New York, London, Frankfurt, Hong Kong, Tokyo, and Sydney. Foreign exchange transactions are executed 24 hours, five days a week. Despite the decentralized nature of foreign exchange markets, the exchange rates offered are the same among its participants because arbitrage opportunities can arise otherwise.
The forex market is accessible because its participants come from diverse fields, including tourists and newcomer traders to large financial institutions and MNCs.
Also, the foreign exchange market does not only involve a simple conversion of one currency into another. Many large transactions in the market affect the application of a wide variety of financial instruments, including forwards, swaps, options, etc.
A foreign exchange gain or loss occurs when a company trades goods and services in a foreign currency, which fluctuates relative to its home currency. Consequently, it can create differences in value in the monetary assets and liabilities, which must be recognized periodically until they are eventually settled.
The exchange rate is the difference in the value of the foreign currency when converted to the seller’s local currency. If the value of the home country currency increases after the conversion, the seller will incur a foreign currency gain.
But, if the value of the home currency reduces after the conversion, the seller will incur a foreign exchange loss. Suppose it is impossible to calculate the current exchange rate at the exact time when the transaction is recognized. In that case, the next available exchange rate can be used to calculate the conversion.
Foreign exchange rates are continually affected by changes in the companies that conduct business abroad. For example, this applies to transactions receiving foreign currency payments from outside the company’s domestic country or sending payments to suppliers from abroad.
Since exchange rates are dynamic, the exchange rate may differ from when the transaction occurs to when it is paid and converted to domestic currency.
