How do international currency exchange rates work

Factual Questions
1

The Euro is now at 1 euro:1.33 USD. I heard my professor talk about when it was 0.89 euros:1USD. I assume this means that back then a dollar could buy 1.5x as much in europe as it can now, but what causes currency to become overvalued or undervalued? Why does the USD go up or down compared to the pound or Euro or Yen? Do international currency rate changes affect domestic prices or do those remain the same?

Are there groups of international tourists who attempt to take advantage of intense currency discrepency to visit countries on the cheap when their economies tank and/or when their domestic economy is doing great? Sounds like a reasonable idea and means to travel internationally if you plan it out.

2

From: http://www.tutor2u.net/economics/content/topics/exchangerates/forex_markets.htm

Fundamental factors that drive an exchange rate

INTEREST RATES

Interest rates have a large effect in a world where financial capital can move freely between countries.

When a country’s interest rates are high relative to elsewhere this attracts inflows of money into a country seeking to take advantage of the high interest rates. This “interest differential” boosts the demand for the currency and can cause its value to rise.

ECONOMIC GROWTH

Countries experiencing a deep recession often find that their exchange rate is weakening. Traders in the currency markets may take the slow growth to be a sign of general economic weakness and “mark down” the value of the currency as a result.

On the other hand, economies with strong “export-led” growth may see their currency’s rise in value. Japan is a good example of this in recent years. The Euro was weak during the first six months of its existence in part because the financial markets were worried about the slow growth of the European economy and the persistently high level of unemployment.

INFLATION

In the long run, those countries with higher than average inflation see their exchange rate fall. When inflation is high, a country becomes less competitive in international markets causing a fall in exports (a demand for a currency) and a rise in imports (a supply of currency overseas). A fall in the exchange rate may be needed to restore a country’s competitiveness in overseas markets.

THE BALANCE OF PAYMENTS

Selling exports represents a demand for the domestic currency from foreign importers. When US consumers but British Whisky they supply dollars and this is eventually translated into a demand for pounds.

Similarly when UK consumers buy imports, they supply their own currency and this is eventually translated into a demand for foreign currencies. If a country is running a substantial trade surplus there is a large demand for the currency and its value should appreciate. By contrast a massive trade deficit usually causes the currency to lose value.

MARKET SPECULATORS

Special factors (such as political events, changing commodity prices etc.) can have an effect on a currency. In addition the power of market speculators has grown. When speculators decide that a currency is going to fall in value, they sell that currency and buy ones they anticipate will rise in value.

It is difficult for government’s to offset the power of speculators because their reserves of foreign currencies are very small compared to daily turnover in the market. We saw in 1997 and 1998 speculative attacks on currencies in Asia and seven years ago, the pound was forced out of the European exchange rate mechanism because of speculative selling of the pound.

3

Unless something interferes to prevent the market mechanism from working, currencies are not overvalued or undervalued. The price is set by supply and demand.

Something often does interfere, of course; governments. The government of country A can fix the price of its currency in (say) euros by announcing that it will buy and sell its own currency, without limit, at a stated exchange rate with respect to the euro. Or it can attempt to manipulate exchange rates through exchange control; fobidding or limiting the right to buy and sell its currency.

More people want to buy USD and are offering EUR in exchange; price of USD (in EUR) goes up (or dollar strengthens agains the euro). Or fewer people want to sell USD in exchange for EUR; same result. And vice versa.

Sure do. And the more open a national economy is (i.e the more it trades internationally) the greater this effect will be.

US dollar weakens; imported goods become more expensive in the US (but goods exported from the US become more competitive abroad).

International tourism is certainly affected by exchange rates. To take a simple example, somebody not in the Eurozone or the US who wants to visit a Disney theme park, and choosing between Disney World in Florida and Eurodisney in France will find that the dollar/euro exchange rate impacts very heavily on the decision.

Well, you can’t really plan it, since future exchange rate movements are not really predictable. You have to be opportunistic about it, being ready to travel at short notice (or alternatively, fixing a date for travel in advance but deferring until the last minute the decision as to where to go). If you could reliably predict future exchange rate movements you’d rapidly become fabulously wealthy and wouldn’t have to worry about devising strategies to keep your holidays cheap.

4

Market forces, you know, the old offer-and-demand. The more people want to change their yen to dollars, the more the dollar will go up relative to the yen. What’s happening right now is that for a number of reasons, more dollars are being sold, hence the low rates.

Now, if you ask what causes exactly those movements, well, if you knew that you’d be a very rich man. There are many factors at play and the currency market is one hell of a dynamic system.

Yes. To give a simplified example. Say I’m an American vendor who imports goods from Japan. I’m buying my stuff in bulk at 1000 yen a piece. If the exchange rate is 110 yen per dollar, that comes out to $9.09. With the dollar at 100 yen, however, it’s $10. If this goes on for a while, I’m going to have to adjust the prices if I don’t want my profits to shrink. Within a global economy, there’s actually very little you can by that doesn’t involve someone at some point buying something from abroad.

Yes. I come from a family of great travellers and when choosing a destination, the exchange rate is a factor. The trip that you could just barely afford is suddenly just out of reach. So you go somewhere else. I think it would be really interesting to compare the traffic at Canadian-American border checkpoints with exchange rates. I’m sure there’s a pretty strong correlation, especially for day and weekend trips.

5

Nothing really positive to add, but this just happened to me recently.

(I) went to the bank to wire money to my new landlord in Mexico (work money, luckily). I sent MX$22,350. This came out to about US$2010.00. Few days later, I find out that the wire transer didn’t take, and the refund was MX$22,350, or since my account here in the States is in US$, US$1940. In a matter of a couple of days, I lost US$70. Luckily, you’ll absorb the loss next time you purchase my company’s products, but still it kind of sucks.

6

Fffft. I’ve lost £2 to exchange rates in the time it took to enter my card details into Expedia. Now that was annoying.

7

I’ve worked for a couple of large companies that had a person working fulltime as a short-term currency trader. This guy took short-term money, that was in the companys’ account already, and wouldn’t have to be paid out for a few days. (These companies paid out a lot of checks, to a lot of people, often with a delay before they were deposited.)

He used that money (in dollars) to buy other currencies, then sell them and buy others, by the end of the day buying enough back in dollars to be able to cover the company checks that would be presented tomorrow. He’d be dealing with a few million dollars each day.

He managed to make a consistent profit on this; enough to cover his own salary, and quite a bit better than leaving it in a bank earning interest.

(We knew about this because all the IT systems that wrote checks had to produce a special file for him, basically listing the amount and date of each check written. From this, he got reports telling him how much money needed to be in the company’s bank account the next day.)