What is Currency Appreciation
Currency appreciation is an increase in the value of one currency regarding another currency. Currencies appreciate against each other for a variety of reasons, including government policy, interest rates, trade balances and business cycles.
BREAKING DOWN Currency Appreciation
Currency appreciation happens in a floating exchange rate system. They are traded in pairs, so a currency appreciates when the value of one goes up compared to another. Think of it like this: Appreciation takes place when exchange rates change, allowing for the purchase of more units of a currency.
But it’s very important to understand that currency appreciation cannot be viewed in the same way as the appreciation of other types of securities. Unlike a stock, of which the price represents its value, a currency quote is the rate at which one currency is exchanged for another. Typically a forex trader trades a currency pair in the hopes of currency appreciation of the base currency against the counter currency.
Appreciation is directly linked to demand. If the value appreciates (or goes up), demand for the currency also rises. By contrast, if a currency depreciates, it loses value against the currency to which it is being traded.
Identifying Currency Appreciation
A standard currency quote lists two currencies as a rate or fraction. For example, USD/JPY = 104.08. The first of the two currencies (USD) is the base currency and represents a single unit, or the number 1 in the case of a fraction such as 1/104.08. The second is the quoted currency and is represented by the rate as the amount of that currency needed to equal one unit of the base currency. The way this quote reads is: One U.S. dollar buys 104.08 units of Japanese yen.
For the purposes of currency appreciation, the rate directly corresponds to the base currency. If the rate increases to 110, then one U.S. dollar now buys 110 units of Japanese yen and, therefore, appreciates. As a rule of thumb, the increase or decrease of a rate always corresponds to the appreciation/depreciation of the base currency, and the inverse corresponds to the quoted currency.
Appreciation of Currencies vs. Stocks
A stock is a security that represents ownership in a corporation for which its officers have a fiduciary duty to conduct operations that result in positive earnings for the shareholder. Thus, an investment in a stock should always be appreciating in value. By contrast, a currency represents the economy of a country, and a currency rate is quoted by pairing two countries together and calculating an exchange rate of one currency relative to the other. Consequently, the underlying economic factors of the representative countries have an effect on that rate. An economy experiencing growth results in a currency appreciating, and the exchange rate adjusts accordingly. The country with the weakening economy may experience currency depreciation, which also has an effect on the exchange rate.
Effects of Appreciation
When a nation's currency appreciates, it can have a number of different effects on the economy. Here are just a couple:
- Export costs rise: If the U.S. dollar appreciates, foreigners will find American goods more expensive because they have to spend more for those goods in USD. That means that with the higher price, the number of U.S. goods being exported will likely drop. This eventually leads to a reduction in gross domestic product (GDP), which is definitely not a benefit.
- Cheaper imports: If American goods become more expensive on the foreign market, foreign goods, or imports, will become cheaper in the U.S. The length to which $1 will stretch will go further, meaning you can buy more goods imported from abroad. That translates to a benefit of lower prices, leading to lower overall inflation.
Currency rates are, therefore, subject to the ebb and flow, or appreciation and depreciation, that correspond with the economic and business cycles of the underlying economies and are driven by market forces.