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The finer details of currency exchange rates

Category Business Investment

the-finer-points-of-currency-exchange

If you’re planning a holiday overseas this Christmas, the falling Aussie dollar has probably got you thinking whether it’s best to buy foreign currency now or hold off in the hope that the dollar recovers.

Foreign exchange (or FX trading) is one of the most complex markets in existence. What seems like a simple conversion of one currency to another can be influenced by such an array of factors that it lends truth to a joke I first heard over 20 years ago. How do you make a million dollars? Start with $5 million and trade currencies!

In 1990, while sitting on the foreign exchange desk as a 20-year-old trainee FX dealer with Investment Bank of Ireland Treasury, I was made acutely aware of the need for confidence and trust for international trade. We were in the midst of global confusion that was the Gulf War after the invasion of Kuwait by Iraq.

What we experienced was a drop of over 75 per cent in international currency trading – to such a degree that dealers were using the Reuters trading screen to run daily quizzes as trade in currency plummeted.

How are exchange rates determined?

Exchange rates between currencies can be either controlled – as in the case of China – or left to the market to decide, as is the case now in Australia.

In the case of controlled exchange rates, the government has complete power and sets a daily trading rate that applies to trade that flows in and out of the country. This process tends to frustrate trading partners, whereas when the exchange rate is left to the flux of the market, the results are often easier to foresee.

” the Australian dollar/British pound exchange rate will depend on how the demand-supply balance moves”

The process is really not different in its essentials from the way any market functions. The supply and demand for different goods determine what their prices are. In this case, substitute currencies for goods or services.

Thus, the Australian dollar/British pound exchange rate will depend on how the demand-supply balance moves. When the demand for our dollar in England rises because they wish to purchase our goods, travel to Australia or invest in our companies or property markets and supply does not rise correspondingly, each dollar will cost more pounds to buy.

Do we gain or lose when the Australian dollar depreciates?

The answer is less simple than it might seem. Australian exporters clearly gain when there is depreciation in our currency since they can price their goods cheaper in pounds and yet earn the same amount of dollars. This makes them more competitive internationally. However, importers lose because their costs go up, and since they are likely to pass this on to consumers, it often means costs in the economy rise.