Economics: Real Exchange Rates

Exchange Rate is the price of one country's currency in terms of another country's currency; the rate at which two currencies are traded for another. It measures the number of units of one currency which exchange, in the foreign exchange market for one unit of another. In International market it is termed as Forex. Exchange rates are important because, they establish the relationships between the different currencies or monetary units of the world. Exchange rates have been instrumental in developing international trade. These have considerably increased the tempo of international investments. They provide a direct link between domestic prices of commodities and productive factors and their prices in the rest of the world. With the prices at home and abroad at a given level, a low rate of exchange will hamper imports and stimulate exports, and thereby tend to bring about a balance of payment surplus. 

Some believe speculators may be able to profit from judging the action of official organizations. Exchange rate forecasting and speculation are both closely related to the issues of the efficiency of foreign exchange markets. By efficiency we mean here the effective use of all relevant information by people buying and selling foreign exchange. After explaining the vehicles of foreign exchange speculation, the evidence on market efficiency is examined.  Then it turns to the record on forecasting exchange-rate, including a comparison of chartist versus fundamental forecasting techniques.  The record of chartists and fundamentalists is back to market efficiency, specifically to the ability to earn from speculation using simple trading rules.  It should be mentioned at the outset that opinions differ widely on the topics discussed and by no means do all finance researchers agree that abnormal speculative returns and market inefficiencies have been detected. 

Nevertheless, despite a traditional predisposition against finding abnormal returns to speculation, market inefficiencies, and chartist forecasting success, when it comes to foreign exchange markets, traditional notions face a challenge.  For example, international organizations and central banks have at times been major players in the foreign exchange market, whereas in most financial markets such as stock markets, there are generally no massive players.  When may think of foreign exchange speculators, they have an image of fabulously rich people in large limousines, wearing vested suits and making handsome profits with little regard for the ordinary citizen.  However, our initial purpose here is not to discuss the possible merits or evils of speculation, but rather to simply describe the different ways to speculate.  As we shall see, these are the same as the different ways to hedge, but when actions are taken without the offset of an underlying exposure such as a foreign-currency account receivable or payable.