Foreign Exchange Market and Foreign Exchange Rate

Hundreds of banks and dealers are active in these markets and very small part of transactions are carried out by using cash. Almost all the transactions (buying and selling orders) are put through using computer systems and telephones and, therefore, they are carried out as digital records. In this way, billions of dollars are transferred among accounts every day. 

It is a wellknown fact that international transactions have an increasing significance in the globalized world. For instance, during the last 20 years, the ratio of foreign trade volume to gross domestic product has increased from 45% to 75%. Foreign exchange markets make these transactions possible by transferring the local currency to foreign currencies or vice versa.

In order to buy a unit of currency, the amount that must be foregone in the other currency is the foreign exchange rate. In other words, the foreign exchange rate is the price of one unit of currency in terms of the other.

The value of foreign currency units in terms of each other is called as the cross foreign exchange rate (sometimes shortly cross rate) like 1$ = 0.89€ or 1€ = 1.12$. 

The foreign exchange rate is the price of one unit of currency in terms of the other. This price, that is the foreign exchange rate, can be explained in two different ways: direct and indirect. It is very important to know the quotation style (direct or indirect) of the foreign exchange rates to decide whether one currency depreciates or appreciates. For instance, most of the European countries use direct quotation while the US uses indirect quotation to explain foreign exchange rates. You should be aware of this especially when you read the books written in the US. 180

The foreign exchange rate allows to determine how much a good, service or financial asset whose value is expressed in terms of a foreign currency will cost in terms of domestic currency.

5.25$ x 5.75$/₺ = 30.18₺ In this case, he has to pay more in the USA than he pays in Turkey in terms of Turkish Liras.

Under the assumption, however, when the amount of Turkish lira increases to buy 1 US dollar, the total amount you should pay also increases and foreign goods are expensive. In other words, domestic currency loses its value against the dollar and it is known as the depreciation of domestic currency.

Turkish lira depreciated against some of these foreign currencies like  USD (US Dollar), EUR (Euro), GBP (British Pound), JPY (Japanese Yen) and CNY (Chinese Yuan) especially after 2017 while it saved its value against CHY in general terms. 

Foreign exchange rate is also known as the nominal foreign exchange rate. Unless otherwise cited, when we say foreign exchange rate it is the nominal foreign exchange rate representing the price of a foreign currency in terms of the domestic currency. If we define the foreign exchange rates in this manner, it does not measure the purchasing power of the domestic currency. The value of a domestic currency against foreign currencies corrected for the purchasing power is called the real foreign exchange rate.

It is the current exchange rate today for immediate delivery. However, forward exchange rate is the exchange rate settled today for a payment or delivery that will be consummated in a future date. 

In the determination process of the foreign exchange rate, it is required to differentiate the long and short term analyses in order to understand the factors affecting the level of exchange rate. 

Fundamental economic variables (like general price levels and real outputs) of two countries are the basic factors affecting the level of an exchange rate. Determination of the equilibrium level of $/T exchange rate in the long run is not different from the price determination process. 

Factors that cause a change in the equilibrium exchange rate are the factors which are accepted as constant other than the current exchange rate (the variable on the vertical axis of the figure). In macroeconomics, these factors include the real GDP, relative productivity, relative price level, barriers for international trade (like tariffs and quotas) and preferences between imported and domestically produced goods. 

The real output (GDP) level of a country is an indicator reflecting the productivity of resources she has. For this reason, an increase in the real GDP of a country, relative to the other causes, shifts the supply and demand curves. 

Suppose that the US economy grows faster than Turkish economy. Holding everything else constant, this means that Americans now demand (buy) more of Turkish goods and assets in the market. Because the payment will be made as dollars, the producers of goods and issuers of assets now have more dollar holdings. This creates an increase in the supply of dollars in Turkey. 

The law of one price: It states that entirely homogeneous (identical) goods should be sold with the same price even in different markets. 

In economics literature, it is claimed that speculative international capital movements toward emerging markets like Turkey is one of the factors that create large fluctuations in exchange rates. One of the suggested measures to prevent this negative effect is to tax the short term capital flows to the country in order to limit mobility. In general terms, this type of taxing is known as Tobin (a well-known economist) tax. 

According to the portfolio preference theory, there are a couple of factors affecting the demand for an asset. Think for a moment that Turkish lira and the US dollar deposit accounts are opened in a Turkish bank. They have similar characteristics as default risk, liquidity and tax considerations. Consequently, the basic factor that affects the demand for these assets is the expected rate of return that could be obtained by holding them. 

The interest parity condition states that the domestic interest rate is equal to the total of foreign interest rate and to the expected rate of change in the foreign exchange rate. 

The Big Mac index was invented by The Economist in 1986 as a lighthearted guide to whether currencies are at their “correct” level. It is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services (in this case, a burger) in any two countries.