Definition of Currency Terminology

Let us begin with some terms in order to prevent confusion in reading this unit:

A foreign currency exchange rate or simply exchange rate, is the price of one country’s currency in units of another currency or commodity (typically gold or silver). If the government of a country- for example, Argentina- regulates the rate at which its currency- the peso- is exchanged for other currencies, the system or regime is classified as a fixed or managed exchange rate regime. The rate at which the currency is fixed, or pegged, is frequently referred to as its par value. if the government does not interfere in the valuation of its currency in any way, we classify the currency as floating or flexible.

Spot exchange rate is the quoted price for foreign exchange to be delivered at once, or in two days for inter-bank transactions. For example, ¥114/$ is a quote for the exchange rate between the Japanese yen and the U.S. dollar. We would need 114 yen to buy one U.S. dollar for immediate delivery.

Forward rate is the quoted price for foreign exchange to be delivered at a specified date in future. For example, assume the 90-day forward rate for the Japanese yen is quoted as ¥112/$. No currency is exchanged today, but in 90 days it will take 112 yen to buy one U.S. dollar. This can be guaranteed by a forward exchange contract.

Forward premium or discount is the percentage difference between the spot and forward exchange rate. To calculate this, using quotes from the previous two examples, one formula is:

Where S is the spot exchange rate, F is the forward rate, and n is the number of days until the forward contract becomes due.

Devaluation of a currency refers to a drop in foreign exchange value of a currency that is pegged to gold or to another currency. In other words, the par value is reduced.

The opposite of devaluation is revaluation. To calculate devaluation as a percentage, one formula is:

Weakening, deterioration, or depreciation of a currency refers to a drop in the foreign exchange value of a floating currency. The opposite of weakening is strengthening or appreciating, which refers to a gain in the exchange value of a floating currency.

Soft or weak describes a currency that is expected to devalue or depreciate relative to major currencies. It also refers to currencies whose values are being artificially sustained by their governments. A currency is considered hard or strong if it is expected to revalue or appreciate relative to major trading currencies.

The next section presents a brief history of the international monetary system form the days of the classical gold standard to the present time.