Forex starter pack: Understanding exchange rates

Markets have not been great in 2022 and people have been looking for avenues to diversify, who knew throwing my savings into Dogecoin because Elon said so would be such a bad idea. One area of diversification comes in your exposure to currencies and since not all of us are able to earn in different currencies, we play in the Forex market by buying stocks, bonds or other investments that are based in other countries. This article is the first in our Forex starter pack series and focuses on exchange rates (if you are here looking for forex signals, you’re in the wrong spot. Check your IG DMs.)

 

What is an exchange rate?

An exchange rate is the price of a country/region's currency (i.e., the dollar) in relation to another country/region's currency (i.e., The Euro). An exchange rate is “fixed” when countries use gold or another agreed-upon standard, and each currency is worth a specific measure of gold or the other standard. An example of a different standard would be a peg, in which one country will decide to set a fixed exchange rate of their currency to that of another currency, commonly the Dollar and Euro. An exchange rate is defined as floating when supply and demand or speculation sets exchange rates. We will discuss some of these factors later in this article.


How to read an exchange rate

Exchange rates can be found on numerous websites and even a quick google search will give you the prevailing exchange rates for a variety of currencies worldwide. In Forex, we refer to ‘currency pairs’ that provide an exchange of one currency for another. An example would be to take the Dollar (USD) and the Rand (ZAR) and place them in a currency pair USD/ZAR or ZAR/USD. All forex trades involve the simultaneous purchase of one currency and sale of another in which we refer to a base currency and a quote currency. The base currency is the 1st currency listed in the currency pair and the quote currency is the 2nd currency listed. When we look at currency pairs, we are looking at how much of the quote currency (2nd listed currency) is required to purchase the base currency (1st listed currency.) So, when you see that USD/ZAR = 17.12, you are being told that currently you need R17.12 to purchase $1.


Understanding the movements (appreciation vs depreciation)

What do currency appreciation and depreciation mean? Currency appreciation is the increase in the value of one currency relative to another. For example, if on July 14th the USD/ZAR currency pair is 17.12 and today it is 16.1, the rand has appreciated as you must pay less rands to get a dollar. Alternatively, you can also have a currency depreciation in which there is a decrease in value of one currency relative to another. Taking our same example, if on July 14th the USD/ZAR currency pair is 17.12 and today it is 18.5, the rand has depreciated relative to the dollar as it now costs more rands to purchase $1.


This can also be expressed in percentages. Using the above examples, if we wanted to calculate the % change for the rand to go from 17.12 to 16.1 relative to the USD we would use the formula ((R2÷R1)-1) x 100 where

  • R1 = previous exchange rate
  • R2 = current exchange rate


This would give us ((16.1÷17.12)-1) x 100 = -5.96%. If the answer is negative, we know that the base currency has depreciated. If the answer is positive, we know that the base currency has appreciated. This tells us that relative to the Rand, the Dollar has depreciated by 5.96%. To work out the quote currency appreciation, you would take the inverse of the exchange rates and use the same formula. This results in ((1÷16.1) ÷ (1÷17.12))-1 = 6.33%. This tells us that relative to the Dollar, the Rand has appreciated by 6.33%


Movement in currency pairs is referred to as percentage interest point or price interest points but they are most commonly referred to as pips. Currency pairs are typically denoted with decimal points (i.e., USD/ZAR - 17.2347) and the pip is typically calculated using the 4th decimal point of the currency pair change. So, If the USD/ZAR price increases from 17.0750 to 17.0785, we say that the USD/ZAR is up 35 pips (R0.0035). There are exceptions to this rule such as the Japanese Yen for which the pip is calculated using the 2nd decimal point.


You can use the pips to calculate the value of exchange rate movements by using the following formula (Value of exchange rate movement = (pip change/current exchange rate) x base currency amount. Let's use an example of the Dollar and Rand (USD/ZAR)

  • Pip increase: 45 (0.0045)
  • Base currency: Dollar (USD)
  • USD/ZAR: 17.1200 (It costs R17.12 for $1)
  • Base currency amount (the amount of $ you want to purchase): $250


This would result in (0.0045/17.1200) x 250 = $0.06571. To convert this back to rands we just multiply by the exchange rate of 17.12 to get R1.125. That is the value of a 45 pip movement to purchase $250 in rands. You can check your math to ensure you are right

  • Previously: $250 x 17.1200 = R4 280.00
  • Currently: $250 x 17.1245 = R4 281.125 


What causes these currency pairings to move? There are various factors that impact exchange rates. We have outlined some of the main ones below

Interest rates

Higher interest rates offer foreign investors a higher return and thus increasing your interest rates will result in greater demand for your currency as investors will be more attracted to opportunities in your country. Therefore, higher interest rates in a country can increase the value of that country's currency relative to nations offering lower interest rates.

Inflation rates

A higher inflation rate in country 1 relative to the country 2 in their currency pair will tend to reduce the value of the currency in country 1 as the purchasing power of country 1 is getting weaker. Inflation impacts the purchasing power of a currency as 1000 units of that currency today does not buy you the same basket of products / services that 1000 units of that currency in a month’s time. Should country 1 have a higher rate of inflation, the value of that currency is decreasing at a faster rate than country 2 and thus, the exchange rate will depreciate.

Geopolitical stability

The general state of a country impacts the investors view of that country and consequently, the demand for that country’s currency. A range of geopolitical events can affect currencies, from general elections and policy announcements to natural disasters and wars. Wars having the greatest impact as seen in the war in Ukraine, the Dollar has appreciated by almost 40% relative to the Ukrainian Hryvnia in the last year. Political instability or tension will cause investors to become uncertain about a country’s future and subsequently result in less demand for that country’s currency as investors become unwilling to invest.

Balance of payments (value of imports and exports)

The balance of payments refers to the net effect of all exports and imports of goods and services within a country for a given period. This influences exchange rates through its effect on foreign exchange supply and demand as exports are paid for by foreigners in your country / region’s currency and imports are paid for by your country / region in a foreign currency. A country with a high demand for its goods and services relative to its imports will have an increasing demand for its currency. Conversely, a country that imports more than it exports will have less demand for its currency.


What has happened to the Rand in 2022?

Given the Rand is largely driven by South Africa’s abundance of resources and commodities which had a strong start to 2022, recovering from the COVID slump. South Africa was also impacted less by events taking place around the world. Russia’s war with the Ukraine has impacted supply chains and commodity prices adding to the existing inflation issues faced in Europe.


There has since been a slowdown in commodity price growth, loadshedding impacting economic growth, and floods in KZN impacting ports and export infrastructure in the country that has hurt the Rand after its positive start. This is compounded by the ongoing war in Ukraine as both Russia and Ukraine are key players in the global food and energy markets. This resulted in rising energy costs, food inflation impacting customer spending, and soaring fuel prices. Fears of recession locally places a grim forecast on the Rand for the remainder of 2022.


We hope you found this guide useful! We know that Forex is a hot topic in SA right now given the global climate so feel free to shout if there are any other topics you want us to dig into.

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