Markets - Foreign exchange market

Theory 5 - Exchange rate jargon - jargon-busting guide

There is a lot of jargon associated with exchange rates. In this theory section we look at some of this jargon, and see what it means.

Spot exchange rates

The spot exchange rate is the rate existing in the market at any given moment. It can be considered as the rate of exchange for immediate delivery of the currency. The spot rate will change all the time according to the changes in supply and demand in the market.

Forward exchange rates

The forward exchange rate is a rate for a given time in the future. A price is agreed now for an exchange at some time in the future (often 3 months or so). Whatever happens to the spot rate between now and then, the contract will be met at the rate that was agreed. Companies may use the forward market to protect themselves against the foreign exchange risk. They know they can buy at a guaranteed rate for the future, and so can plan ahead. This process is called 'hedging' against risk. The existence of the forward market also creates the potential for speculation. Depending on the reason for buying or selling the currency the dealer could end up better off or worse off.

Purchasing Power Parity

The purchasing power parity exchange rate is the exchange rate between two currencies, which would enable exactly the same basket of goods to be purchased. In other words, the rate at which purchasing power will be the same in both countries. For example, say a basket of goods cost $50 in the USA, and the same basket cost £25 in the UK. The PPP rate between the £ and the $ would then be £1=$2. The PPP rate is often used when trying to work out consistent measures between countries like GDP or standard of living. It will generally be different to the actual equilibrium exchange rate, though it will be a factor influencing it.

Effective Exchange Rate

The effective exchange rate is also called the 'sterling index' or perhaps the 'sterling trade-weighted index'. It is an exchange rate calculated from a basket of currencies, and can perhaps best be thought of as an average exchange rate. Each of the currencies included is weighted according to its importance to us. This is worked out from the amount of trade we do with that country. The currency of a country that we do a large amount of trade with will have a higher weight than one whom we do relatively little trade with. The effective exchange rate can be a useful indicator, as it shows overall exchange rate changes. An individual currency may be affected by factors unique to that country, but the effective exchange rate will still give an overall indication.