I know a thing or two about the currency market, so I might as well share what I think you may find valuable. Most of the basics will be accessible in your dreaded friend the textbook, but I found it quite limited in terms of explaining. Exchange rate related questions are usually straight-forward on Multiple-Choice papers, but on essays, you'd need to take it up a notch, if you ever find yourself in the situation where you'd need to answer one! Keep in mind, you don't need to know the tiny and itty-bitty details. Like other posts on Study Retreat, the information provided should act as the victorious cherry-on-top to further push you academically. Let's get started!
Exchange rates in simple terms are basically. the value of one currency to another. Like say, the British Pound against the US Dollar. Foreign exchange pairs (two currencies, get it? Pairs? like pairs of shoes!) are quoted as e.g. GBP/USD, that is, the rate of the GBP (Pound) vs. the USD. A currency is said to appreciate over another if it gains relative value. In contrast, a currency is said to depreciate (NOT DEVALUE, thats a whole different term) when it loses relative value against another currency. The currency (or foreign exchange market, or in short 'forex') is the most liquid (the most active) market in the world, with $3 trillion+ circulating (exchanged) every day, 24 hours, five days a week (except weekends). Who participates in the Forex market? The graphic below explains just that.
Exchange rates in simple terms are basically. the value of one currency to another. Like say, the British Pound against the US Dollar. Foreign exchange pairs (two currencies, get it? Pairs? like pairs of shoes!) are quoted as e.g. GBP/USD, that is, the rate of the GBP (Pound) vs. the USD. A currency is said to appreciate over another if it gains relative value. In contrast, a currency is said to depreciate (NOT DEVALUE, thats a whole different term) when it loses relative value against another currency. The currency (or foreign exchange market, or in short 'forex') is the most liquid (the most active) market in the world, with $3 trillion+ circulating (exchanged) every day, 24 hours, five days a week (except weekends). Who participates in the Forex market? The graphic below explains just that.
Worry not, if they don't make sense to you, you don't need to actually know what each of these are for the AS level course. To keep it simple, Put it this way. The general ratio of the playas in the Forex market is 80/20. That is 80% are non-speculative participants, and 20% are speculative participants. On average. Now, What the flippin' zip does that mean?
Speculation basically means participating purely for good ole buck; for profit as the main motive. What's an example of a speculative participant? A fund manager, a person/firm that puts up money as an investment purely for the seeking of profit. Like George Soros, who made over $1 billion shorting (an investing lingo word for selling) the British Pound in September 1992. A non-speculative participant, is a market participant that does not participate because of a direct profit motive. It can be a company for example. Say, Toyota. Toyota's a Japanese car manufacturer and they want to build a massive factory in Germany. Germany is part of the Eurozone, and they use Euros as their currency right? Toyota would have to convert their Japanese Yen to Euros. Still speaking about companies, let's say Toyota made massive buck over the past 5 years and has the objective of taking over Ford. (mama-mia!) This is called an acquisition. To "buy" Ford, Toyota has to exchange Japanese Yen to US Dollars. On the micro-level as well, you, when you're at the airport, travelling, and changing currencies, you are actually participating in the currency (foreign exchange) market! Anyhow.. how about central banks?
Central banks! They're big momma juggernauts, and are the largest participants in the foreign exchange market. These are big government authorities which are responsible for setting monetary policy for a country; that is to set things like interest rates at levels where they deem it's best for the economy, to control inflation, the steady rise in prices, for example, or keep the currency at a level where it is economically at a 'fair' level. Usually a central bank does not directly intervene, meaning they rarely use up their currency reserves (shitloads of foreign currency that they stockpile) to affect the exchange rate. Direct central bank interventions can have significant effects on exchange rates. A recent example of this, is in the EUR/ISK rate (Euro vs Icelandic Krone), where the CBI, the central bank of Iceland continuously purchased its own currency, and caused it (the Icelandic Krone) to appreciate against currencies like the Euro, as a direct result of their participation.
Speculation basically means participating purely for good ole buck; for profit as the main motive. What's an example of a speculative participant? A fund manager, a person/firm that puts up money as an investment purely for the seeking of profit. Like George Soros, who made over $1 billion shorting (an investing lingo word for selling) the British Pound in September 1992. A non-speculative participant, is a market participant that does not participate because of a direct profit motive. It can be a company for example. Say, Toyota. Toyota's a Japanese car manufacturer and they want to build a massive factory in Germany. Germany is part of the Eurozone, and they use Euros as their currency right? Toyota would have to convert their Japanese Yen to Euros. Still speaking about companies, let's say Toyota made massive buck over the past 5 years and has the objective of taking over Ford. (mama-mia!) This is called an acquisition. To "buy" Ford, Toyota has to exchange Japanese Yen to US Dollars. On the micro-level as well, you, when you're at the airport, travelling, and changing currencies, you are actually participating in the currency (foreign exchange) market! Anyhow.. how about central banks?
Central banks! They're big momma juggernauts, and are the largest participants in the foreign exchange market. These are big government authorities which are responsible for setting monetary policy for a country; that is to set things like interest rates at levels where they deem it's best for the economy, to control inflation, the steady rise in prices, for example, or keep the currency at a level where it is economically at a 'fair' level. Usually a central bank does not directly intervene, meaning they rarely use up their currency reserves (shitloads of foreign currency that they stockpile) to affect the exchange rate. Direct central bank interventions can have significant effects on exchange rates. A recent example of this, is in the EUR/ISK rate (Euro vs Icelandic Krone), where the CBI, the central bank of Iceland continuously purchased its own currency, and caused it (the Icelandic Krone) to appreciate against currencies like the Euro, as a direct result of their participation.
Continuing...There's two types of exchange rate systems/mechanisms. There's the floating exchange rate mechanism, which means that the rate is let free to be 'set' by the forces of supply and demand. That is, the buying and selling activities of the market participants previously described above. Most currency mechanisms today of modern economies are adopting the floating system. Below is a graphic that shows the advantages and disadvantages of a floating exchange rate mechanism.
There's also a fixed exchange rate mechanism, where oppositely, an exchange rate is 'set' to only be traded around a specific boundary. These boundaries are called trading bands. Sometimes, certain price levels are defended by authorities by central banks as part of their monetary policy objectives. These price levels are called pegs/'floors/ceilings (floor if its a level below current prices, ceiling if its above current prices. Below are some advantages and disadvantages of a fixed exchange rate mechanism.
One recurring question that comes up again.... and effin' again on essay questions is: Explain what is meant by fixed and floating exchange rate mechanisms (12). Or some form of that question. Here's a general example of a paragraph structure of such a question.
1. Define what is an exchange rate, and the currency market in general for the introductory paragraph.
2. Mention that there are two differing exchange rate mechanisms, and each carry their own distinct advantages and disadvantages.
3. Body paragraph 1: Start with (e.g.) floating exchange rates. Explain it in full, not forgetting to explain terms like 'inflation' or 'GDP' for example. Give example of floating exchange rate for context.
4. Body paragraph 2: Talk about fixed exchange rates. Again, remembering to not forget to explain related terms. Give example of a fixed exchange rate. Elaborate well on a specific case study to further develop on your description.
5. Conclusion: Finish up by having a neutral and objective write-up that both have their own advantages and disadvantages, and that most modern economies have a 'centrist'/combinations of both.
1. Define what is an exchange rate, and the currency market in general for the introductory paragraph.
2. Mention that there are two differing exchange rate mechanisms, and each carry their own distinct advantages and disadvantages.
3. Body paragraph 1: Start with (e.g.) floating exchange rates. Explain it in full, not forgetting to explain terms like 'inflation' or 'GDP' for example. Give example of floating exchange rate for context.
4. Body paragraph 2: Talk about fixed exchange rates. Again, remembering to not forget to explain related terms. Give example of a fixed exchange rate. Elaborate well on a specific case study to further develop on your description.
5. Conclusion: Finish up by having a neutral and objective write-up that both have their own advantages and disadvantages, and that most modern economies have a 'centrist'/combinations of both.
Personally I think, to achieve that A grade is pushing it with just knowing book-content material, but if you have got that extra oomph to expand, for context and historical examples... you will surely get an A in addition to your course-only knowledge. How do we input context? DONT OVERDO IT. Context is good in sprinkles with knowledge-type questions, as cherries on top, not the whole sundae ice cream!
Going back to that very same example question, you could further develop on explaining that pegged rates can fail, with the case of South East Asia in 1997-1998 for example, in the Asian financial crisis. Thailand is a popular example, where the lack of enough foreign currency reserves caused their exchange rate to be then freely floated, which had it ended up losing 40% of its value in one year (which is huge. You could talk about the Swiss National Bank's (Switzerland's Central Bank) massive intervention in 2011, to devalue their swiss franc, as it was too strong at the time during the Eurozone crisis. Swiss exporters had a hard time selling their goods/services to Europe, and that's why the SNB intervened. You can use that as an example to talk about how that even floating exchange rates, are not purely floating, but can be 'managed' as well. There's an example right there! Another one... when talking about floating exchange rates, you could (very briefly) talk about how Bretton Woods fell apart (a global gold-standard fixed exchange rate) broke down after World-War II and that's when global exchange rates started to float!
Well, that's that for now! I will be uploading a sample essay soon to this post in regards to fixed/floating mechanisms coupled with annotations as well to help you out!
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