6.2 Foreign exchange rates  (Page 2/4)

If the South African Rand is our domestic (or home) currency, we call the ZAR/USD rate a “direct" rate, and we call a USD/ZAR rate an “indirect" rate.

In general, a direct rate is an exchange rate that is expressed as units of home currency per units of foreign currency, i.e., $\frac{\mathrm{Domestic\; Currency}}{\mathrm{Foreign\; Currency}}$ .

The Rand exchange rates that we see on the news are usually expressed as direct rates, for example you might see:

The exchange rate is just the price of each of the Foreign Currencies (USD, GBP and EUR) in terms of our domestic currency, Rands.

An indirect rate is an exchange rate expressed as units of foreign currency per units of home currency, i.e. $\frac{\mathrm{Foreign\; Currency}}{\mathrm{Domestic\; Currency}}$ .

Defining exchange rates as direct or indirect depends on which currency is defined as the domestic currency. The domestic currency for an American investor would be USD which is the South African investor's foreign currency. So direct rates, from the perspective of the American investor (USD/ZAR), would be the same as the indirect rate from the perspective of the South Africa investor.

Terminology

Since exchange rates are simply prices of currencies, movements in exchange rates means that the price or value of the currency has changed. The price of petrol changes all the time, so does the price of gold, and currency prices also move up and down all the time.

If the Rand exchange rate moved from say R6,71 per USD to R6,50 per USD, what does this mean? Well, it means that $1 would now cost only R6,50 instead of R6,71. The Dollar is now cheaper to buy, and we say that the Dollar has depreciated (or weakened) against the Rand. Alternatively we could say that the Rand has appreciated (or strengthened) against the Dollar.

What if we were looking at indirect exchange rates, and the exchange rate moved from $0,149 per ZAR (= $\frac{1}{6,71}$ ) to $0,1538 per ZAR (= $\frac{1}{6,50}$ ).

Well now we can see that the R1,00 cost $0,149 at the start, and then cost $0,1538 at the end. The Rand has become more expensive (in terms of Dollars), and again we can say that the Rand has appreciated.

Regardless of which exchange rate is used, we still come to the same conclusions.

In general,

• for direct exchange rates, the home currency will appreciate (depreciate) if the exchange rate falls (rises)
• For indirect exchange rates, the home currency will appreciate (depreciate) if the exchange rate rises (falls)

As with just about everything in this chapter, do not get caught up in memorising these formulae - doing so is only going to get confusing. Think about what you have and what you want - and it should be quite clear how to get the correct answer.

Discussion : foreign exchange rates

In groups of 5, discuss:

1. Why might we need to know exchange rates?
2. What happens if one country's currency falls drastically vs another country's currency?
3. When might you use exchange rates?

Cross currency exchange rates - (not in caps, included for completeness)

We know that exchange rates are the value of one currency expressed in terms of another currency, and we can quote exchange rates against any other currency. The Rand exchange rates we see on the news are usually expressed against the major currencies, USD, GBP and EUR.