Learn Forex Trading: An Exchange Rates Tutorial
Profits are gained and lost on the foreignexchange, or ‘Forex’ market, due to flucuations in the exchange rate. This fact may seem like common knowledge, but how exchange rates are determined should not be taken for granted.
There is actually a very rich history behind the concept of the exchange rate, understanding why things came to be as they are is important — as well as how to capitalize on that knowledge.
This quick tutorial on exchange rates will help you do just that.
First, lets look at the simplest definition of an exchange rate. An exchange rate is the value of one currency in relation to another. If one U.S. dollar is worth $1.20 Canadian, then the exchange rate is 1:1.2, or 1.2 for the CAD/USD currency pair.
What does this really mean, though? How can one currency be worth more than another, and who makes that decision?
In order to answer that question you must first look back to the early part of the 20th century. In those days, most currencies of the world were backed by precious metals like silver and gold.
In those days, the United States followed the ‘gold standard’ which ‘pegged’ the Dollar to the price of 1 ounce of gold. The worlds other currencies were then tied to the value of the dollar and allowed to fluctuate in either direction by a margin of no more than 1 percent.
Even though this type of exchange rate allowed for minor flucuations, it was considered a ‘fixed’ exchange rate.
Now, fast-forward to the latter half of the century, and you find that the ‘gold standard’ has been dropped, along with the fixed rate model of exchange. Instead, the foreign exchange market now operates primarily on a ‘fluctuating exchange rate’.
Fluctuating exchange rates are governed by the market forces of supply and demand. If the demand for a currency exceeds the supply, then the exchange rate (and value) of that currency will rise.
Likewise, if the supply of a currency exceeds market demand, then the value of that currency (and its exchange rate) will drop.
We see this happening today with the U.S. Dollar. In order to keep up with government spending, the federal reserve prints more and more dollars, then sells them to other countries as ‘debt’.
Learn More About Forex Exchange Rates
The market forces which previously gave the dollar its strength, such as oil exports and oil transactions denominated in U.S. dollars, have eroded. This has not only weakened the value of the dollars exchange rate, but the exchange rates of many of our closest tarding partners as well.
As an example,the Japanse Yen has dropped even more than
the dollar. This is due in part to an overall crash in the Asian market, but it is also linked to the fact that much of Japan’s economic growth at the end of the last century depended upon exports to the United States.
This is just one example of how market forces affect exchange rates, but it is a useful one for examining some of the factors involved in rate fluctuations.
As you stay abreast of world and financial news, see if you can spot the relationships between major announcements and rate fluctuations!
You can find more information on currency exchange rates in this outstanding forex trading guide.
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