Currency Exchange Introduction Introduction to how exchange rates can fluctuate
Currency Exchange Introduction
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- What I want to do in this video is to give you an intuitive sense of how a market for currencies would actually work.
- And it's very nonintuitive for a lot of people.
- Because we're going to be talking about currencies becoming more expensive or cheaper —
- or the price of a currency [becoming more expensive or cheaper] in terms of another one.
- And what I just want to do is give you a very intuitive feel for that.
- So let's say — just because it's a hot topic right now —
- let's just make the two currencies the Chinese renminbi and the U.S. dollar.
- And the unit of exchange — and China's a little confusing —
- Because sometimes they use the word "renminbi" — sometimes they use the word "Yuan."
- The Yuan is the unit of [exchange for] the renminbi.
- So let's say right now, if I were to just go on some website —
- And this is not the actual exchange rate right now.
- But let's say, right now, the quoted exchange rate is 10 Yuan per U.S. dollar.
- 10 Yuan is equal to 1 US dollar.
- And every time I say "dollar" in this video, I'm referring to the US dollar. ( — is equal to 1 US dollar.)
- I think this makes sense to a lot of people.
- If I have one dollar, [and] I want to convert it to Yuan, I get 10 of them [Yuan].
- If I have 10 Yuan and I want to convert [them] to dollars, someone is going to give me a dollar for [them].
- Now let's imagine a situation —
- (And in the next few videos, I'll construst actual trade imbalances where this would actually happen.)
- But let's say we live in a reality where there are 1,000 —
- — so let's say someone has 1,000 Yuan.
- So let's say that this person right here has 1,000 Yuan — and wants to convert to dollars.
- Now, let's say, on this side —
- And if we just superficially looked at this 1000 Yuan — and looked at the quoted rate,we'd say
- "Hey, that 1000 Yuan — you divide, you get 10 Yuan/dollar, so that should be a hundred dollars, at the quoted rate."
- Let's say you have two other actors over here.
- And obvioulsy, this market involves many, many more than just three people.
- But this will help us simplify or at least understand, how these exchange rates would work.
- Let's say that this person right here —
- let's say that this person right here with the mustache —
- let's say that this person right over there, and maybe a hat as well —
- Let's say that he has 50 dollars — he has 100 dollars that he needs to convert to Yuan.
- Maybe he wants to buy some Chinese goods.
- Maybe he is a Chinese factory owner who sold his goods in the US for 100 dollars.
- And now he needs to convert it back to Yuan to pay his employees
- or pay his own mortgage, or who knows what.
- And let's say that there's another person — Let's say there's another character over here.
- And let's say that she also she also has a hundred that needs to be converted into Yuan.
- So, net-net, what's happening here?
- What's the total demand to convert Yuan into dollars, and dollars into Yuan?
- Well, if you look at the whole market, you have $200 that need to be converted into Yuan.
- So let me write this down.
- We have a situation where 200 dollars need to be converted into Yuan.
- And then, on the other side of that transaction, we have 1000 Yuan that need to be converted into dollars.
- So, now we have 1,000 Yuan need to be converted into dollars.
- And for simplicity, these are the only actors. They are representing the entire market.
- Although, as we know, in currency markets especially, there are thousands — or even millions —
- of actors actively participating in them.
- So what's going to happen?
- All of these people might just go on the Internet, and look up the current exchange rate
- or the last exchange that occurred — and [say]
- "Hey, you know what, me over here, this $100, I should be able to convert into a 1000 Yuan."
- But she also says "I should be able to convert this 100 dollars into a thousand Yuan."
- So they collectively think that that 200 dollars can be converted into 2000 Yuan.
- So I'll put this in question marks.
- So will they be able to convert this into 2000 Yuan?
- And on this person over here, he's saying, "Well, just at the current exchange rate
- maybe I'll be able to get for my thousand yuan — maybe I'll get 100 dollars."
- But everyone wants to maximize the amount of the other currency they get — for obvious reasons.
- They want to maximize the amount of money they get.
- Now. Will these 2 people be able to convert their money into 2000 Yuan?
- Remember. What I said is that this is the entire market.
- It's a huge [over]simplification.
- But there is this imbalance here: more dollars into Yuan than Yuan into dollars.
- Now, they won't be able to convert into 2,000 Yuan, because there's only 1,000 Yuan that wants to be traded.
- (There's only 1,000 Yuan that wants to be traded.)
- So you could imagine, this guy over here, maybe he wants to do it slowly, just to kind of see what the market is like.
- So, let's say, at first he puts 10 Yuan up — essentially for bid.
- You could do it either way.
- You could say that maybe one of these people put a dollar up for bid.
- And this guy is bidding on that dollar in terms of Yuan.
- Or this guy is putting Yuan up for bid.
- And these guys are going to bid on it in terms of dollars.
- Either one. And that's why it's sometimes confusing with currency.
- It's because you are buying another currency.
- But since this guy['s currency] is more in demand —
- To simplify things, I'll make him the person that's kind of able to create an auction-type situation —
- which really is what the markets are trying to do, so that you can equalize supply and demand.
- So he might put out — he might initially say: "Hey, you know what? I want to convert —"
- He has 100 Yuan, and he wants to convert it.
- So he says, "You know what? I'm willing to sell 100 Yuan for $10."
- So, let's say he sells 100 Yuan for 10 dollars.
- So he sells 100 — or offers, I should say — offers to sell 100 Yuan for 10 dollars.
- She just thinks that's a fair offer price, right over there.
- And that's this guy over here, this guy actually converting yuan into dollars.
- Well, what's going to happen?
- Well, one of these people are just going to jump at that.
- They say, "Oh. You know what? I think that's a fair price."
- And so, let's say, this woman right over here takes it.
- Actually both of them, maybe, saw that offer to sell 100 Yuan for 10 dollars.
- And they both tried to click their mouse, or however they're trying to make the transaction [happen].
- But let's say she clicks her mouse a little faster, and she gets the transaction.
- So let's say — Let's call this Person B, and this is Person A, and this is Person C.
- So Person B accepts. So two things happened just then.
- One is, Person C says, "Well, that was pretty fast."
- "Someone was very willing to take it for 10 yuan per US dollar."
- And then this guy goes, "Oh my! I need to convert my money into Yuan; but I wasn't able to."
- "Someone else beat me to the punch!"
- So this guy over here is like, "Hey, maybe people are willing to give me more dollars per yuan."
- So, let's say that this guy right over here — this guy in orange — he then offers to sell.
- Let's say he wants to sell 90 yuan for 10 dollars.
- Notice. The price of the Yuan has now gone up — or the price of the dollar has now gone down.
- Either one, those are symmetric statements. They mean the exact same thing.
- So, all of a sudden, this person has a lot of dollars he needs to convert into Yuan.
- So he accepts really fast. So, person A accepts.
- And I'm doing a huge oversimplification.
- But it gives you the general idea to show you that this really is a market.
- So Person A accepts.
- All of a sudden we have a new quoted exchange rate.
- All of a sudden we have an exchange rate of —
- What is this? — 9 Yuan.
- So we have [a] new quoted rate — or the transaction happens at 9 Yuan per dollar.
- Now, what's happening?
- And I think you see the dynamic that is going to happen.
- There are more dollars that need to be converted into Yuan than Yuan that need to be converted into dollars
- So, this guy — as he sees that there's a lot of demand to get his 1000 Yuan —
- he's going to keep offering fewer and fewer Yuan per dollar.
- Or, these guys are going to start accepting fewer and fewer Yuan for each of their dollars.
- So, as this happens, the price of the Yuan will go up.
- Notice: the price of Yuan went up here.
- It was 10 Yuan per dollar; now it is 9 Yuan per dollar.
- Or you can say that the price of the dollar has gone down.
- And this will just keep happening until all of them are able to get rid of their currency.
- It's actually dependent.
- There's no mathematical formula to say what the clearing price is.
- It's actually dependent on how badly each of these people are willing to transact
- and really how good they are at gaming each other.
- But the general results here — and this is what I really want you to get from this video
- is that because there's no law in a market exchange rate mechanism that says,
- "This has to be the exchange rate" — we'll explore how you can peg it in the future
- but there's nothing that says that this has to always be the case.
- If there's more demand for Yuan than dollars — as we see in this example —
- the price of the dollar will go down.
- I'll do this in a — Price of dollar will go down. And then —
- which is the exact same thing — which means the exact same thing as,
- "The price of yuan will go up —"
- I really want you to internalize this.
- — will go up in terms of dollars.
- [The] price of dollars, in terms of Yuan, will go down.
- And this is the crux of foreign exchange.
- If you can, at least, internalize these ideas and understand that there really is this market out here,
- based on the supply and demand of Yuan.
- Over here, the demand for Yuan is exceeding its supply so price will go up, and —
- Or you can do it the other way.
- The demand for dollars is below its supply. So, the price will go down.
- Anyway, I'll let you think about that for a little bit.
- And in the next video, we're going to apply this concept to see how this freely floating exchange rate
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