Currency Appreciation

What is 'Currency Appreciation '

Currency appreciation is an increase in the value of one currency in terms of another. Currencies appreciate against each other for various reasons, including government policy, interest rates, trade balances and business cycles. Currencies are quoted and traded in pairs. Unlike a stock, of which the price represents its value, a currency quote is the rate at which one currency is exchanged for another.

BREAKING DOWN 'Currency Appreciation '

It’s very important to understand that currency appreciation cannot be viewed in the same way as the appreciation of other types of securities.

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 similarly represents the economy of a country, and a currency rate is quoted by pairing two countries and calculating an exchange rate of one currency relative to the other. Consequently, the underlying economic factors of the representative countries has 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.

The important distinction between a stock and a currency is that for a stock perpetual value appreciation is expected. Conversely, for a currency, too much appreciation can have a negative impact on the underlying economy. For example, for a country with an appreciating currency, imports become cheaper, which translates to a benefit of lower prices, leading to lower overall inflation. However, that same currency appreciation makes exports more expensive to foreign buyers and ultimately curtails demand for the country’s products. This eventually leads to a reduction in gross domestic product (GDP), which is definitely not a benefit. 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.

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 faction such as 1/104.08. The second currency 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.