How exactly are exchange rates determined?

Question

I was reading about how the exchange rates are fixed. I understand that demand and supply decide the exchange rate but how exactly is it done and by whom?

For example, consider US and India. (https://www.quora.com/Where-and-how-are-exchange-rates-determined)

When it comes to any currency, say US dollars, Demand for the currency exists due to the following reasons:

1. Import of goods and services from the USA

2. Direct purchases made in the USA by Indian tourists

3. Foreign investment by Indians in the USA

4. Speculative trading by Indians

5. Payment of international loans

6. Gifts and grants to the rest of the world

A currency(USD) is in supply due to the following reasons:

1. Export of Indian goods and services

2. Purchases by American tourists in India

3. FDI by Americans in India

4. Speculative trading by Americans in the Indian Rupee

5. Remittances from the USA

Depending on which of the factors outweighs the other factors, the exchange rate is determined.

Okay, but these are vague terms. Who decides "Purchases by American tourists in India", how can anyone keep track of these things, and how exactly are these factors decided? Is there a person sitting in an office somewhere who inputs some numbers in a formula and thus obtains the exchange rate?. I have a very limited understanding of economics so please bear with my noob question.

Answer 1

1. Currencies are indeed "actually" traded basically on what is called the "Interbank Market"

Here's a quick read on that:

https://en.wikipedia.org/wiki/Foreign_exchange_market

Let us compare and contrast!

• Stocks (like AAPL) are (as a rule) traded on the two or three huge "stock exchanges" such as "Nasdaq", which everyone has heard of.

• Commodities like gold and oil are (as a rule) traded on the two or three huge "commodities exchanges", such as "Nymex", "CME", etc, which many have heard of.

• And to your question, currencies generally are traded on the huge "Interbank Market" (as nicely described in that article).

This is a (fairly! - see below) free market. The price is determined exactly, each second, by buyers and sellers.

It is an OTC distributed system, and very much an insider's market, which is broken in to tiers with the top tier being a small number of he world's huge banks.

The literal trading amongst this group (that is to say, "the database, communications, etc") is handled by a shadowy concern called EBS (which indeed, "they" set up) (again, you need only turn to Wiki .. https://en.wikipedia.org/wiki/Electronic_Broking_Services )

That is the only "real" price of a currency - the volume of the top tier is just overwhelmingly, astoundingly, large, and hence "is" the current price.

Just as Nasdaq continually reports the "actual" price of AAPL to the internet, and Nymex continually reports the "actual" price of gold and oil to the internet, the Interbank Market (on a literal technical level, basically "EBS") continually reports the "actual" price of EUR, AUD, etc to the internet.

So in a sense the simple answer to your question ..

"Where do currency prices come from?"

is:

"From a little-known behind-the-scenes technical platform called EBS. They handle the OTC trading of a tight group of the biggest players - the world's hugest financial institutions. They trade freely and openly in unbelievably large volumes, but each tier of access is very much a "club". {Indeed, some see it as a cartel; there was indeed a spectacularly large scandal about this in recent times.} This is all in general known as "the Interbank Market".

2. When you go to a local exchanger at the airport, they simply use that current rate, i.e. ultimately from the "Interbank Market" system.

Your question is astute...

When "you or I" change some money, the money changer retail shop on the street is not "trading", it's not a situation where two parties offer bids/asks. The shop simply offers a fixed price to buy or sell different currencies, and that fixed price is simply based on the current price seen on the "actual" market. (Exactly the same thing happen when you buy some ounces of gold from a retail gold dealer.)

To make a contrasting example - when you buy a house from some person, it's an actual trade with bids/asks by the parties involved, which will settle at some price. And when you buy stocks (even 1 share) it's more or less an actual bids/asks situation.

Just to reiterate, this wiki article https://en.wikipedia.org/wiki/Foreign_exchange_market pretty much fully explains the interbank market. Which is indeed the worldwide currency "exchange" - which is analogous to the Nasdaq "exchange" for stocks or Nymex "exchange" for gold and oil.

Many see this as a cartel; as it explains on wiki:

"Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the interbank foreign exchange market, which is made up of the largest commercial banks and securities dealers..."

(indeed that precisely is where the price the OP is asking about comes from, via, on simply a technical level, the "EBS" platform which they set up and now use)

...which led to the spectacular "Forex Scandal" of our times, and here's the latest on that. Reading the articles on the zillion-dollar scandal, illuminates the overall scene.

(The only thing more "fixed" is the London gold fix, which is set each afternoon by five particular players in cahoots.)

Answer 2

Here's a very simple way to determine the exchange rate between dollars and euros, assuming you have a few dollars:

1. Go from place to place and ask them how many euros they'll give you for your dollars. Accept the best offer you get.
2. Go from place to place and ask people how many dollars they'll give you for your euros. Accept the best offer you get.
3. If you made a profit, go back to step 1.
4. Average the two exchange rates you got the last time you executed steps 1 and 2.
5. This is the exchange rate between dollars and euros.

As there are markets that permit people to offer and accept trades between currencies all over the world, this process is constantly going on in large amounts in numerous places with every currency known to man. Currencies worth a total of approximately $5 trillion per day are traded in this way. From this stream of trades, the exchange rates can readily be determined.

All of the factors listed in the question affect what trades people are willing to make. But the rate is determined from the trades people actually make. The same is true with the price of a car. The cost of steel and the cost of labor go into the price of a car. But when you want to know the price of a car, what you want to know is what price people are actually buying and selling cars for, and you determine this by looking at car sales.

Answer 3

No one applies the factors to calculate an exchange rate (for freely floating currencies) — it’s not calculated at all, but determined from what actually happens in the market. People who want to buy currency A with currency B bid on how much of currency B they are prepared to give in order to get currency A. Similarly, people who want to buy currency B with currency A also bid. When the bids match up, a transaction happens, and that is the exchange rate, until the next transaction. Since in practice the rate won’t vary very much from minute to minute for actively traded currencies, places that exchange small amounts of cash for consumers will set a rate for the day rather than checking the current rate every time they do a transaction.

Answer 4

There are two things going on here.

First, how "the price" is determined. There are actual real-time buying and selling of currency and future promises to deliver currency going on. This is called the ForEX market, for "Foreign Exchange market".

This market is relatively high volume and stable for most major currencies. People make money on the market mostly through highly leveraged positions, where they put up X dollars, borrow 10X dollars, and use that to speculate. As long as they are buying a major currency, the person lending them money figures they can recoup their money before it drops by a factor of 10.

The last buy/sell on this market (or averages between them) is the "rate of exchange" that you can find on the internet.

You are probably not buying on this market. Possibly you are going to some kiosk somewhere and paying money for some other currency.

These kiosks peg their rate to that market. They have actual bills there, and bank accounts. They take the rate, add a premium on it, and offer to exchange money based on that. They are betting that the rate of exchange won't change so fast that they'll lose money on restoking their cash, and that they'll make a healthy profit on the premium.

So if the EURO is 1.1 USD, at the Kiosk they might sell EURO for 1.15 USD and buy USD for 0.85 EURO. That 5% is their profit margin.

Credit cards and banks will offer the same thing, electronically; they'll convert your electronic USD for electronic Rupees. The price they'll offer is based off ForEX markets, plus a premium. They might even make a trade of the ForEX market to buy/sell the expected currency of each type that they need that day. Or they might initially operate on credit (where they borrow the Rupees you buy), then clear it later (at the end of day), again trusting that their premium will cover any currency flux.

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Now the reason why people talk about sources of Demand and Supply is that if there is a whole pile of Demand for Rupees and not much for USD, over time the price will tend to move. This is because there isn't an infinite amount of Rupees and USD up for sale. If demand for Rupees grows, people start having problems getting the Rupees they need. Companies that stock exchange kiosks with money buy out the "lowest offer" Rupees, and buy from higher offer ones. Same goes for Banks buying Rupees that they offer to their customers on their credit cards, or when clearing their debts.

The price of Rupees goes up, USD goes down, and quickly people reconsider buying some good from India, or liquidate some Indian bonds and move it to the US. This provides a force pushing the price the other way, as the supply of Rupees on the market increases and USD goes down.