Exchange rates float freely against one another, meaning that their values fluctuate constantly in the foreign exchange market, called the forex or the FX for short. The value of a currency is determined largely by the flows of currency into and out of the country that issues it. A high demand for a particular currency usually means that the value of that currency will increase.
Currency demand is driven by many factors including foreign trade, tourism, speculation, and the perception of the nation’s geo-political risks.
When a company in Japan sells products to a company in the U.S. the U.S.-based company needs to convert dollars into Japanese yen to pay for the goods. That flow of dollars into yens signals demand for the Japanese yen. If the total currency flow leads to a net demand for Japanese yen, the yen will increase in value against the U.S. dollar.
Key Takeaways
- Currencies constantly fluctuate in value as they are traded on the international market known as the forex or FX.
- Currency trading is dominated by banks and institutional investors that are exchanging money for their business customers or making a profit from fluctuations in currency prices.
- About 180 currencies are traded but the big four are the U.S. dollar, the Japanese yen, the British pound, and the euro.
What Is the Forex?
The forex, or foreign exchange market, is decentralized. It has no headquarters and no owner. Currency trading is accomplished via trading platforms provided by brokers.
Understanding Exchange Rates
Currencies are traded 24 hours per day around the world. Local trading hours may vary but currency trade and banking are always underway somewhere in the world. Trading is conducted electronically and there is no centralized exchange.
Banks process transactions globally for their business customers, so they are constantly converting their local currencies into foreign currencies to fulfill transactions. As banks around the world buy and sell currencies, the values of those currencies fluctuate.
Currency traders leap on the bandwagon, making money by exploiting fractional changes in one currency’s value against that of another.
Interest Rate Impact
Adjustments to interest rates made by monetary policymakers in each country also have a great effect on the values of their currencies.
Currency traders take advantage of these fluctuations in interest rates. If an investor can earn 3% interest on deposits in the United Kingdom and can borrow money in Japan for 1%, the investor might borrow money denominated in Japanese yen to buy money denominated in British pounds.
This constant demand causes additional fluctuation in the value of the major currencies.
A total of 180 currencies are traded in the forex market. However, the market is dominated by just four currencies: the U.S. dollar, the British pound, the Japanese yen, and the euro.
Who Are Currency Traders?
It is possible, thanks to the internet, for an individual investor to trade in currency, but it remains rare.
Most currency traders are buying and selling currencies on behalf of the global banks, institutional investors, or national central banks such as the U.S. Federal Reserve.
What Is an Exchange Rate?
An exchange rate is the value of one currency in comparison with the value of another currency.
When the financial media says, for example, “the British pound is falling” or “the pound is rising,” it means that a British pound could be exchanged for fewer or more U.S. dollars.
Why Does the Exchange Rate Matter to Travelers?
When you travel abroad, the real buying power of your U.S. dollars is determined by the current exchange rate. For example, if you flew to London in late December 2023, you could exchange $100 U.S. dollars for about 79 pounds sterling. Only months before, in March, you would have gotten about 84 pounds for your $100. By the end of the year, the pound had strengthened in relation to the U.S. dollar, so your money was worth less.
Why Does the Exchange Rate Matter to Consumers?
The current exchange rate determines the real cost of imported goods that people buy. If the Japanese yen grows stronger against the U.S. dollar, the goods Japan sells in the U.S. will increase in price. American visitors to Japan will pay more dollars for goods and services there, too.
This is why economists debate the benefits of a “strong dollar.” A strong U.S. dollar means that American goods and services cost more to consumers in other countries. Consumers abroad reconsider their purchases and switch to products produced in their own country.
The Bottom Line
Currency trading is a constant, 24-hour process that is necessary to accomplish global trade and incidentally provides an opportunity to make a profit from the constant fluctuations in their values.
