In finance, an exchange rate (also known as a foreign-exchange rate, forex rate, or rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency.
The exchange rate is defined as the rate on the basis of which two countries involved in trade exchange marketable items or commodities. It is basically the cost of exchanging one currency for another currency.
In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer’s margin (or profit) in trading, or else the margin may be recovered in the form of a commission or in some other way.
Different rates may also be quoted for different kinds of exchanges, such as for cash (usually notes only), a documentary form (such as traveler’s checks), or electronic transfers (such as a credit card purchase). There is generally a higher exchange rate on documentary transactions (such as for traveler’s checks) due to the additional time and cost of clearing the document, while cash is available for resale immediately.
Therefore, the exchange rate can be calculated as per the below-mentioned relationship:
Exchange Rate = Money in Foreign Currency / Money in Domestic Currency
Additionally, it can also be determined as per the below-mentioned relationship:
Exchange Rate = Money in After Exchange / Money Before Exchange
The equation for the exchange rate can be calculated by using the following steps:
- First, determine the amount that is to be transferred or exchanged from domestic currency to foreign currency.
- Next, the individual can access foreign exchange markets through trading platforms or through financial institutions to determine the available exchange rates prevalent between the two nations.
- Next, multiply the exchange rate with the domestic currency to arrive at the foreign currency.
Purchasing Power Parity
Purchasing power parity is a way of determining the value of a product after adjusting for price differences and the exchange rate. Indeed, it does not make sense to say that a book costs $20 in the US and £15 in England: the comparison is not equivalent. If we know that the exchange rate is £2/$, the book in England is selling for $30, so the book is actually more expensive in England
If goods can be freely traded across borders with no transportation costs, the Law of One Price posits that exchange rates will adjust until the value of the goods are the same in both countries. Of course, not all products can be traded internationally (e.g. haircuts), and there are transportation costs so the law does not always hold.
The concept of purchasing power parity is important for understanding the two models of equilibrium exchange rates below.
Balance of Payments Model
The balance of payments model holds that foreign exchange rates are at an equilibrium level if they produce a stable current account balance. A nation with a trade deficit will experience a reduction in its foreign exchange reserves, which ultimately lowers, or depreciates, the value of its currency. If a currency is undervalued, its nation’s exports become more affordable in the global market while making imports more expensive. After an intermediate period, imports will be forced down and exports will rise, thus stabilizing the trade balance and bringing the currency towards equilibrium.
Asset Market Model
Like purchasing power parity, the balance of payments model focuses largely on tangible goods and services, ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. The flows from transactions involving financial assets go into the capital account item of the balance of payments, thus balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model.
Accounting Treatment of Exchange Difference Approach # 1. Single Transaction Approach:
Single transaction approach is based on the premise that any transaction and its settlement is a single event. So if any exchange difference is there that may be charged to cost of goods purchased or to an export sale.
Accounting Treatment of Exchange Difference Approach # 2. Double Transaction Approach:
In contrast to single transaction approach, Dual transaction approach considers exchange element separately, hence emphasizes on accounting treatment of both separately. In other words, purchase or sale is recorded in the books of accounts at the exchange rate prevailing at the date of transaction and adjustments are not made for any change in exchange rates. These changes in exchange rates on different dates are treated as expenses and charged to loss on foreign exchange account.