Currency Pricing
Overview
To ask what the price of an asset is, has a hidden assumption buried in it. Priced in terms of what? Typically, the answer is
dollars (or any other domestic currency). So if IBM stock is trading at $100, that means that you can exchange one share of
IBM stock for $100, or the reverse. This highlights the fact that what is actually occurring, is an exchange of two different
assets in such a proportion that is supported by the market. That is, the price of IBM is $100, but one could just as easily
have said that the price of $100 is 1 share of IBM stock.
Switching from a mindset of a single asset with a price, to two assets traded in proportion to their relative values
is the appropriate mindset when trading currencies. In this case, both items in the exchange is a currency, so thinking
in terms of prices can be awkward, rather, the appropriate way to think of trading currencies is the exchange rate.
(as noted in the IBM example, one can view the price of IBM as the exchange rate between IBM and dollars...)
Spot versus Forward Rates
The spot rate of a currency pair is the price of the exchange of the given currencies right now. The forward rate is the rate
of exchange for an exhange of currencies to take place at some point in the future.
(for information on forwards, please see
forwards)
Factors Affecting Exchange Rate
- Purchasing Power Parity :
is a measure of how much a given currency can purchase relative to another currency at the current exchange rate.
That is, if a given amount of currency can buy a specified basket of goods, can the same basket of goods be purchased
after exchanging the currency into a different currency. When currencies are not at parity, it is believed that market forces
will exert pressure on the exchange rate to move toward parity.
- Inflation :
a currency that experiences inflation will generally cause its value in terms of other currencies not exeperiencing the same level of
inflaction to decline, due to the forces detailed above. (PPP)
- Current Real Interest Rates :
Currencies for which a higher real interest rate can be obtained will trade at a premium to other currencies.
This is due to the fact that investors will move towards investments with higher returns. (after accounting for risk)
Trade Strategies
