Understanding What Foreign Exchange Rates Are

Understanding Foreign Exchange Rates

Most people are aware of foreign exchange rates and the fluctuations involved with it.  Many travellers will have noticed that it rarely remains static and it often fluctuates during a single day.  There are many people who profit from these fluctuations.  These are the foreign exchange traders who buy and sell different currencies in the hope of making a profit.

Many people wonder how these rates are defined and who makes the decision as to the value of a currency.  Why do the rates fluctuate constantly instead of remaining at one level?

The Use of Purchasing Power Parity

This is the quickest way to describe why the rates fluctuate constantly.  Purchasing power parity is a theory that the exchange rate should reflect the cost of basic goods in two different countries.  An example of this theory is that a loaf of bread in Australia would cost AUD2 and in America it would cost USD1.  Using the logic of PPP, you can see that one US dollar would be equal to two Australian dollars, and the other side being one Australian dollar being worth 50 US cents.  This is an extremely simplified example of the theory and in practice it is far more involved with more complex calculations required.

The Use of Supply and Demand

Supply and demand play a massive role in the daily fluctuations of foreign exchange rates.  When the demand for a particular currency increases and the supply of that currency remains the same or is lower than the demand, the currency value will increase.  The other side of this equation is when the currency’s supply is higher and there is not sufficient demand for that particular currency, the rate will decrease.

Foreign Exchange Rates and Purchase Transactions

There are several other reasons that may affect the demand for a certain currency.  One of these is the requirement for purchase transactions.  An example to illustrate this is if a party resident in Australia wishes to purchase an item from the United States, they would need to convert their Australian dollars to US dollars to pay for the goods.  There are many of this type of transaction that is undertaken on a daily basis and the total value of currency required steadily increases.  This constant movement of currencies can affect the value of a particular currency.

Purchase transaction payments are not limited to individuals, but large corporations also fall into this category.  Many corporations also need to transfer funds between their offices to pay for salaries and other expenses if it is a branch office.

The Investors

The foreign exchange traders play a massive role in the supply and demand of a currency.  The forex market is huge and boasts a trading volume of around $5 trillion each day.  Many of the traders in this market trade similar currency pairs every day and this will eventually affect the demand for a currency.  For example, an economic announcement may be made which pushes one currency to the top of the list for traders.  This will increase the demand for that particular currency which means its value will increase.

 

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