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Forex exchange rates

Forex exchange rate represents the relation of two currencies' values towards each other. It generally shows what amount of one currency is required to purchase one unit of another. Better understanding of this thing will let you start easier at Forex.

Most currencies on Forex are traded against the US dollar (USD). Four other most-traded currencies are EUR (the euro), JPY (the Japanese yen), GBP (the British pound sterling), and CHF (the Swiss franc). Sometimes AUD (the Australian dollar) is also included into this group of currencies called "the Majors" (because they form the majority of the currencies traded in Forex).

Quotations

The first currency in the exchange pair is referred to as the base currency and the second currency as the counter or quote currency. The counter or quote currency is thus the numerator in the ratio, and the base currency is the denominator. The value of the base currency (denominator) is always 1. Therefore, the exchange rate tells a buyer how much of the counter or quote currency must be paid to obtain one unit of the base currency. The exchange rate also tells a seller how much is received in the counter or quote currency when selling one unit of the base currency.

Important terms

Just to give you an example of how the Foreign exchange rate can work and to help you better understands it we can compare the United States dollar with the Japanese yen. Let's say that on a certain day the US dollar is able to buy one hundred and ten Japanese yen, this would indicate that the exchange rate for that day is 1:110, or one to one hundred and ten ratio.

This ratio in the exchange rate is also known as pairing. When you take it vice versa, you can use it to indicate how many US dollars a single unit of Japanese yen can buy. Another term that is used in the Foreign exchange rate is 'cross rates'. This term however is only used when it does not involve US dollars; it is only used when relating two foreign currencies.

A few other terms used in the Forex exchange are pips or basis points, which are two terms used for the same thing. These terms are used to indicate Forex rates that are calculated up to four decimal points and whether or not these are negative or positive movements. An example of this would be if you were to exchange euros with yen at a value of 135.1030, but then the euro rate goes up to 135.1035, it is called a five-pip improvement.

In using the Forex exchange rate you are required to use two currencies and this means they are quoted as 'two tier' rates. Also in the Forex market its price basis is called a bid/ask. Using the previous ratio between the yen and the US dollar in the Forex market, if this trade is made it is called a ten pip 'spread' and is secured. This term means it indicates the difference between the buying and actual selling price.

Many things can change the spread and affect it. These things include market conditions and traders' instincts about the strength of certain currencies, which can fluctuate greatly from day to day. One thing you should remember however, when it comes to the Forex is that only Forex traders who are licensed can access official quoted rates. This means therefore that smaller investors may not receive their currency at a very good rate, because they usually receive them from commercial banks.

One last thing concerning the Forex exchange rate is that it is independently determined. This is why it thrives so well, because solely buyers, sellers, and their supply and demand of certain currencies determine it. In the end, individual governments and banks cannot decide the values.

Nominal and real exchange rates

The nominal exchange rate is the rate at which an organization can trade the currency of one country for the currency of another. The real exchange rate is an important concept in economics though difficult to grasp in reality. The real exchange rate is defined as rer=e(P/P*) where e is the exchange rate as number of foreign currency units per home currency unit and P is the price level of the home country and P* the foreign price level.

Unfortunately, in real life there is not just one foreign currency and not just one price level -so the calculation of the real exchange rate gets more complex. Further, the above definition is based on purchasing power parity (PPP) which implies a constant real exchange rate, which could not be verified empirically. PPP would imply that i.e. the real exchange rate was the rate at which an organization can trade goods and services of one country for those of another.

For example, say the price of a good increases by 10% in the UK with a 10% appreciation in the Japanese currency against the UK currency. Well, regardless of the price increase for people in the UK, the price of the good will remain constant for someone in Japan. In cases where tariffs become an issue, this would be less the case. More recent approaches try to model the real exchange rate by a set of macroeconomic variables such as relative productivity and the real interest rate differential.

Fluctuations in exchange rates

A market-based exchange rate will change whenever the values of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply (this does not mean people no longer want money, it just means they prefer holding their wealth in some other form, possibly another currency).

Increased demand for a currency is due to either an increased transaction demand for money, or an increased speculative demand for money. The transaction demand for money is highly correlated to the country's level of business activity, gross domestic product (GDP), and employment levels. The more people there are out of work, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions.

The speculative demand for money is much harder for a central bank to accommodate but they try to do this by adjusting interest rates. An investor may choose to buy a currency if the return (that is the interest rate) is high enough. The higher a country's interest rates, the greater the demand for that currency. It has been argued that currency speculation can undermine real economic growth because large currency speculators may deliberately create downward pressure on a currency to force that central bank to sell their currency to keep it stable. Once this happens, the speculator can buy the currency back from the bank at a lower price, close out their position, and thereby take a profit.

In choosing what type of asset to hold, people are also concerned that the asset will retain its value in the future. Most people will not be interested in a currency if they think it will devalue. A currency will tend to lose value, relative to other currencies, if the country's level of inflation is relatively higher, if the country's level of output is expected to decline, or if a country is troubled by political uncertainty.

For example, when Russian President Vladimir Putin dismissed his Government on February 24, 2004, the price of the ruble dropped. When China announced plans for its first manned space mission, synthetic futures on Chinese Yuan jumped (since China's currency is officially pegged, synthetic markets have emerged that can behave as if the Yuan was floating).

Like the stock exchange, money can be made or lost on the foreign exchange market by investors and speculators buying and selling at the right times. Currencies can be traded at spot and foreign exchange options markets. The spot market represents current exchange rates, whereas options are derivatives of exchange rates.