**Foreign Exchange Rate (Forex Rate)** is the ratio, rate, or price at which one country's currency is converted into another country's currency. It can also be described as the price of foreign currency expressed in terms of domestic currency. Foreign exchange transactions are generally concentrated in commercial banks and other financial institutions. These institutions engage in forex trading for profit, buying low and selling high to earn from the difference in prices. The exchange rate used when purchasing foreign currency is called the **buying rate** or **bid price**, while the rate used when selling foreign currency is called the **selling rate** or **ask price**.
### Basic Definition of Foreign Exchange Rate:
Under the **direct quotation method**, the **buying rate** is the amount of domestic currency a bank pays to buy one unit of foreign currency, and the **selling rate** is the amount of domestic currency a bank receives when selling one unit of foreign currency. The **mid-rate** is the average of the buying and selling rates: (Buying Rate + Selling Rate) / 2 = Mid-Rate. This mid-rate applies to inter-bank forex transactions, implying no profit is made between banks during these transactions.
### Overview of Foreign Exchange Rates:
The concept of foreign exchange has dual meanings: dynamic and static. In its dynamic sense, foreign exchange refers to the specialized business activity of converting one country's currency into another to settle international debts and claims. It is a shortened term for international money transfer (Foreign Exchange). In its static sense, foreign exchange refers to payment instruments denominated in foreign currencies that can be used for international settlements. These include credit instruments and securities denominated in foreign currencies, such as bank deposits, commercial drafts, bank drafts, checks, government bonds, and short- or long-term securities. According to the International Monetary Fund, foreign exchange consists of claims held by monetary authorities (central banks, currency management agencies, exchange stabilization funds, and treasuries) in the form of bank deposits, treasury bills, and short- or long-term government bonds, which can be used to offset balance of payments deficits.
According to China's revised **Foreign Exchange Administration Regulations** of January 1997, foreign exchange refers to the following payment instruments and assets denominated in foreign currencies that can be used for international settlement:
1. Foreign currencies, including paper money and coins.
2. Foreign currency payment instruments, including bills, bank deposit certificates, corporate bonds, and stocks.
3. Foreign currency securities, including government bonds, corporate bonds, and stocks.
4. Special Drawing Rights (SDRs), European Currency Units (Euros).
5. Other foreign exchange assets.
The term "foreign exchange" commonly refers to its static meaning, i.e., foreign currencies or payment instruments denominated in foreign currencies that can be used for international settlements. The exchange rate, also known as the exchange price, is the price of one country's currency expressed in terms of another country's currency, or the exchange ratio between two currencies. In the foreign exchange market, exchange rates are displayed with five digits, such as EUR 0.9705, JPY 119.95, GBP 1.5237, CHF 1.5003. The smallest change in an exchange rate is one point, which corresponds to a single digit change in the last position, such as EUR 0.0001, JPY 0.01, GBP 0.0001, CHF 0.0001. By international convention, three-letter codes are used to represent currencies; the English codes after the Chinese names refer to the respective currency codes.
Exchange rates, also known as foreign exchange market rates or exchange prices, are the ratios at which one country's currency is exchanged for another's, representing the price of one currency expressed in terms of another. Due to differences in currency names and values across countries, a fixed exchange rate must be established between currencies.
Exchange rates are the most important adjustment levers in international trade. Since the cost of goods produced by a country is calculated in its own currency, these goods must compete in the international market, where their costs will be related to the exchange rate. Fluctuations in exchange rates directly affect the cost and price of goods in the international market, thereby influencing their competitiveness.
For example, a product worth 100 RMB, if the USD/CNY exchange rate is 8.25, would have an international market price of $12.12. If the USD/CNY exchange rate rises to 8.50, meaning the US dollar appreciates and the RMB depreciates, the international market price of the product would be $11.76. A lower price enhances competitiveness, making it easier to sell and boosting exports. Conversely, if the USD/CNY exchange rate falls to 8.00, meaning the US dollar depreciates and the RMB appreciates, the international market price of the product would be $12.50. Higher-priced goods are harder to sell, negatively impacting exports. Similarly, a stronger US dollar and weaker RMB would restrict imports to China, whereas a weaker US dollar and stronger RMB would greatly stimulate imports.
You should now understand why Japan and the United States often demand RMB appreciation. A stronger RMB increases the cost of Chinese exports on the international market, reducing their competitiveness and stimulating imports of their goods. You should also understand why China's commitment to not devaluing the RMB during the Asian financial crisis was a significant contribution to the international community. If the RMB had been devalued, the financial crises in other countries would have worsened!
Due to the wide-ranging impact of exchange rate fluctuations on import and export trade, many countries and regions adopt relatively stable currency exchange rate policies. The rapid and steady growth of China's imports and exports owes much to the stability of the RMB exchange rate policy.
### Exchange Rate System:
An **exchange rate system**, also known as an **exchange rate arrangement**, is the system by which countries determine the exchange rate of their currency against others. It involves systematic regulations for determining, maintaining, adjusting, and managing exchange rates, including principles, methods, forms, and institutions. The exchange rate system significantly influences the determination of exchange rates in various countries. Reviewing and understanding the exchange rate system allows us to better comprehend the fluctuations in exchange rates in the international financial market. Based on the degree of exchange rate fluctuation, the exchange rate system can be divided into **fixed exchange rate systems** and **floating exchange rate systems**.
A **fixed exchange rate system** is a system where the exchange rate is pegged to a specific value, usually based on the gold content of the currency or another benchmark, resulting in relatively stable exchange rates. Different types of fixed exchange rate systems exist under different monetary systems.
A **floating exchange rate system** is a system where there is no official pegging of the exchange rate to gold or any other benchmark, and the central bank does not maintain any obligation to keep the exchange rate within certain limits. Instead, the exchange rate fluctuates freely according to supply and demand in the foreign exchange market. Historically, this system existed but became widely adopted after the collapse of the dollar-centered fixed exchange rate system in 1972.
### Reasons for the Emergence of Foreign Exchange Rates:
1. **Trade and Investment**
Importers and exporters pay in one currency when importing goods and receive payment in another when exporting goods. This means they deal with different currencies when settling accounts. Therefore, they need to convert part of the currency they receive into a currency that can be used to purchase goods. Similarly, a company buying foreign assets must pay in the local currency of the country where the asset is located, so it needs to convert its domestic currency into the local currency.
2. **Speculation**
The exchange rate between two currencies changes with the supply and demand for those currencies. Traders can make profits by buying a currency at one exchange rate and selling it at a more favorable rate. Speculation constitutes a large portion of transactions in the foreign exchange market.
3. **Hedging**
Due to fluctuations in the exchange rate between two related currencies, companies with foreign assets (such as factories) may face risks when converting these assets back into their domestic currency. Even if the value of foreign assets denominated in foreign currency remains unchanged over a period, changes in the exchange rate can result in gains or losses when converting these assets into domestic currency. Companies can eliminate this potential gain or loss through hedging, which involves executing a foreign exchange transaction whose outcome offsets the gains or losses caused by exchange rate fluctuations.
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