Forex Rate of Exchange

A free market is built on one concept: the price system. Through the price system, buyers and sellers discover what the price of a good or service is worth to them and agree on a mutual price they will use to exchange. The same principle is at work in the foreign exchange (forex) market. The only difference is that the “good” being bought and sold is a foreign currency. With 175 currencies in existence worldwide, the price system is incredibly complex in the forex market. Traders and speculators are up against central banks, international corporations, foreign governments, international financial institutions, soldiers of foreign militaries and humble tourists.

To understand how pricing works in the forex market requires understanding the basic form of a price. In forex, every currency is valued in terms of every other currency. When two currencies are valued in terms of each other, the result is a pair of exchange rates. The structure of an exchange rate represents what a participant is doing when he purchases that rate. The order of the currencies determines which one is bought and sold. An example of an exchange rate is the USD/JPY, where USD represents the U.S. dollar and JPY represents the Japanese yen. When a trader buys this rate, he is selling U.S. dollars to buy Japanese yen.

Another aspect of exchange rates is they all represent different currency pairs. This is a natural consequence of the fact that every currency is simultaneously valued against every other currency. In practice, there are a few major currencies; consequently, the major pairs that use those currencies see most of the liquidity in forex. The eight major currencies are the U.S. dollar, the Australian dollar, the Canadian dollar, the British pound, the Swiss franc, the euro, the Japanese yen and the New Zealand dollar. Out of these eight currencies come a number of major currency pairs. Traders and speculators focus on currency pairs involving these currencies because counterparties and liquidity abound.

The most basic trade in forex is the carry trade. Each currency comes with a specific interest rate set by the central bank issuing that currency. Since interest rates are always different, traders and speculators seek to earn a profit by selling a low-rate currency and buying a high-rate currency. The trader pockets the difference between the two. Additionally, carry traders hope to buy a currency that appreciates against the currency they are selling. That way, they get both the interest rate differential and enjoy substantial capital gains on their original investment.

The exchange rate may look simple, but it conceals a wealth of information that market participants use to their advantage. Central banks are the major market movers with interest rate decisions sending traders scrambling for new positions. The consequent rippling side-effects make changes across the global forex market. Traders must pay attention to these financial behemoths in order to maintain profitability. An unexpected rate hike or decrease can ruin a trader’s positions faster than he realizes, leaving him in the dust.

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