On financial information sites or specialized pages of newspapers, we can read for example EUR/GBP=0.8250/0.8252. The first prize is sales course of the first currency mentioned, here the euro. The second prize is purchase price of the first currency.

In explicit terms, EUR/GBP=0.8250/0.8252 means that one Euro (EUR) sells for 0.8250 Pound Sterling (GBP) and one Euro can be purchased for 0.8252 Pound Sterling. The convention is that these exchange rates are expressed with four digits after the decimal point.

For the sake of simplicity and in order to establish an international standard that allows you to talk about all currencies wherever you are in the world without language barriers, each currency has a three-letter abbreviation. Often – but this is far from being a general rule – the first two letters indicate the country, and the third refers to the name of the currency. For example, here are the abbreviations for the currencies of the United States, Great Britain, China and Japan:

USD US for United States, D for dollar
GBP GB for Great Britain, P for pound (book in French)
CNY CN for China, Y for yuan
JPY JP for Japan, Y for yen

Note: the euro is a notable exception since it has the abbreviation EUR.

Finally, we cannot assess the value of a currency in absolute terms. This is why it is always expressed relative to another currency by an exchange rate, and by observing variations of this rate over time. Each currency therefore has an exchange rate with respect to each of the other currencies. We speak of bilateral exchange rate to designate the exchange ratio between two currencies and the effective exchange rate when we consider all bilateral exchange rates. To establish it, each bilateral exchange rate is generally weighted by the share of the country's international trade carried out in this currency.

## Why are exchange rates important?

Exchange rates have great importance for a country's economyand in particular for its foreign trade.

For example, suppose that the euro appreciates against the dollar, that is to say that the exchange rate of the euro against the dollar increases and goes from 1€=1.35\$ to 1€ =\$1.50 a few months later.

Regarding goods and services, products exported by the United States to Eurozone countries will then be more competitive. Example: 1 “made in USA” DVD for \$20 was worth €14.8 in the Euro zone (i.e. \$20/\$1.35). It will be worth €13.3 (or \$20/\$1.50) a few months later. Conversely, products exported from the Eurozone will have a higher price in USD and will be less competitive in the United States compared to local products.

But, if there is not sufficient national production to avoid importing more – which can be the case for energy or raw materials often coming from emerging countries – this can be a inflation factor in the country whose exchange rate is falling, in this case the United States in our example.

Finally, at the individual level, with an increase in the euro/dollar, American tourists will have a purchasing power decreasing, and conversely the stay of French or German tourists in the United States will be cheaper for them. When it comes to investments, European assets are worth more to American investors and American assets are worth less to investors in the euro zone: a fall in the dollar therefore logically benefits investments in the United States.

Currency exchange rates are set in the foreign exchange market. Each country or monetary zone decides on its exchange rate regime, fixed or floating.

## Exchange rate policies

In the European Union, the euro zone constitutes a monetary zone in which the exchange rates of the member countries have been fixed irrevocably, the local currencies having been replaced by a common currency. On the other hand, the euro is in a floating exchange rate regime vis-à-vis most other currencies. Outside the euro zone, certain states such as Poland or Romania have floating exchange rate regimes. Denmark, on the other hand, maintains a quasi-fixed exchange rate against the euro.

Under floating exchange rates, the United States and the euro zone have adopted a laissez-faire policy with regard to the evolution of exchange rates. Thus the European Central Bank does not intervene in the foreign exchange market to influence the euro exchange rate. Since 2005, China has opted for a floating exchange rate administered with reference to a basket of currencies. Between July 2005 and July 2008, the yuan (also called renminbi) appreciated by around 21% against the dollar. But this system was suspended in July 2008, effectively reestablishing the fixed link between the yuan and the dollar, in the name of the necessary protection of the Chinese economy against the consequences of the global financial crisis.

This situation gives rise to discontent among China's economic partners – the United States in the lead – because this control exercised by the People's Bank of China (the Chinese central bank) over the national currency leads, according to them, to an undervaluation of the yuan on the foreign exchange market. Donald Trump notably accused China of keeping its currency artificially low. However, this criticism, founded in the past, seems to have lost its relevance from 2016 since the Chinese yuan has appreciated and is no longer considered undervalued (estimate what the price should be “normal” of a currency is difficult, however, and there are disagreements about it).

Following the crisis which hit the euro zone from 2010-2011, the currency market found itself facing a new case of central bank intervention in foreign exchange matters. Indeed, the Swiss National Bank (SNB) had decided to set a floor rate euro/Swiss franc following a very strong appreciation of its currency in 2011; increase due largely to uncertainties over the repayment of sovereign debts in the euro zone and the United States.

However, these interventions by the Swiss National Bank ended in January 2015, immediately leading to an increase in the Swiss franc, i.e. the euro falling below the floor rate.

## Equilibrium exchange rate?

Balanced exchange rates, neither overvalued nor undervalued, would in principle correspond to a situation of internal and external balance of the different economies. However, determining equilibrium exchange rates is not an exact science, and it is difficult to estimate the under (or over) valuation of a currency.. Generally, to assess what the equilibrium exchange rate should be, we use the purchasing power parity method, that is to say the exchange rate expected to balance the price of a basket of goods between two country. For example, if the same basket of goods costs 100 euros in Europe and 120 dollars in the United States, then the equilibrium exchange rate is estimated at 1 euro = 1.2 dollars (we divide 120 by 100).

## The strong instability of exchange rates

In fact, since floating exchange rate regimes have predominated, that is to say since the 1970s, equilibrium exchange rates have great difficulty becoming a reality. On the contrary, the instability of exchange rates is a major characteristic of the current global economy.. Thus, for example, from 1999 to 2002 the dollar appreciated by 45% compared to the emerging Euro. Then from 2002 to 2009 it lost 75% of its value. Exchange rate fluctuations of 5% or more over a month are not uncommon. For example, between the end of October and the end of November 2010, the euro lost 8% against the dollar, following the Irish financial crisis.

As an illustration, we can observe the evolution of the euro/dollar rate since the launch of the euro in 1999:

Stabilization of exchange rates therefore seems difficult. First of all, there is a diversity of regimes in place: although the trend since the 1970s has been that of an expansion of floating exchange rate regimesome currencies keep a fixed exchange rate regime, and certain central banks no longer hesitate to intervene to impose an exchange rate favorable to their economy. Finally, it is clear that the currency market has become more speculative since the liberalization of the 1970s. Thus certain fluctuations on the foreign exchange market are not necessarily correlated with the real state of the national economies of the currencies concerned.

It is therefore essential, especially for multinationals and banks which manage very large volumes of liquidity and are exposed to several currencies, to hedge against strong exchange rate fluctuations. The foreign exchange market gives them access to various hedging instruments such as forward transactions or more complex derivative products such as swaps or options.