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Foreign Exchange

Foreign exchange brokers monitor rates carefully prior to making buying decisions.

Foreign exchange rates are updated daily. [©Jupiter Images, 2009]
©Jupiter Images, 2009
Foreign exchange rates are updated daily.

Foreign Exchange

The foreign exchange is a broad term describing the markets and variables that allow people from different countries to make international financial transactions. For example, if investors in the United States want to buy shares of a company based in a member country of the European Union, they will first need to find out how many Euros each dollar is worth. Once the value is determined, which is called the exchange rate, they can then determine how many shares of the company they are able to buy. This process of converting one country's currency into another's is the driving force behind the foreign exchange and its financial markets.

The Exchange Rate

The exchange rate is probably the single most important financial factor within the foreign exchange. Simply put, the exchange rate is how much one country's currency is worth in terms of another's. Although some people may think of the exchange rate as a permanently fixed quantity, often it is much the opposite the value of each country's currency moves up and down each day in response to different economic stimuli, including the country's domestic interest rate and inflation.

Of course, some governments peg their exchange rate at a certain value and use strict financial policies to keep it there, but many do not, leaving the rate to fluctuate according to international supply and demand. Also, it is important to remember that an exchange rate is only a measure of one currency's value relative to that of another. In other words, the rate does not ascribe any true value to the currency, nor does it tell investors how much the currency is worth in terms of goods or services sold in either domestic or international markets.

Inflation, Interest Rates and the Foreign Exchange

Taken as a whole, the economic forces governing the exchange rate are enormously complex. However, there are a handful of relatively simple factors that have a clear and predictable impact on the rate. Inflation is the first of these factors, and is one of the most important. According to Investopedia, during a period economic or price inflation, the domestic value of a country's currency decreases, meaning people need more money to pay for basic goods and services. One of the best examples of inflation occurred in Germany during the early 1920s, when prices rose so sharply in response to the government's feverish printing of paper money that an entire wheel barrel filled with German Marks was insufficient to purchase a single newspaper.

At one point, one U.S. Dollar was worth approximately one trillion German marks. While this is an extreme example of hyperinflation, it demonstrates the point well when prices rise, the real value of money drops, decreasing spenders' purchasing power and weakening the economy. In response to this drop in domestic value, a country's currency loses worth in the international market, lowering its exchange rate. For more information on inflation in the United States, investors can learn about the Consumer Price Index (CPI) and other important factors at the Bureau of Labor Statistics.

Another major factor behind the exchange rate is interest rates. Often determined by a country's central bank or federal government, interest rates control and affect many important financial products, including mortgages, loans, credit cards and certain investments. Because higher interest rates give lenders within a country better returns relative to those in another country, they tend to attract capital from foreign investors, increasing the value of the country's currency and causing the exchange rate to rise. Likewise, when domestic interest rates fall, they tend to drive away foreign investors, causing the currency to lose value on the international market.

Other Influences on the Exchange Rate

A government's current-account deficits, public debt, terms of trade and overall economic health also have a noticeable effect on its currency's exchange rate. When two countries trade with each other, they record the quantity and price of their imports and exports, which includes goods, services, dividends and interest. If one of the countries spends more on foreign trade than it earns, then it typically borrows capital from outside (foreign) sources to make up the difference, also known as a current-account deficit. From the country's point of view, this means that the demand for foreign currency is high relative to the demand for its own, causing its currency to lose value and its exchange rate to drop.

Similar to current-account deficits are terms of trade -- ratios that compare a country's export prices to import prices. If international demand for a country's exports increases, then the prices of its exports will rise. The money it receives from these increased revenues then improves the value of its currency, which in turn boosts its exchange rate.

Also important in the minds of foreign investors and trading partners is a country's political stability and economic health. In general, these groups will only invest their capital in countries with strong economic performance, low economic risk and minimal public debt.

The Foreign Exchange Market

According to the U.S. Department of the Treasury, the foreign exchange market, or FOREX, is the market in which investors buy and sell different currencies. It is the world's largest and most liquid financial market, moving an astonishing average of nearly $2 trillion a day in traded currency. For some sense of scale, consider that as of March 2008, the New York Stock Exchange moved a comparatively small average of $169.6 billion a day. Because it is open 24 hours a day, 5 days a week, the FOREX is also one of the world's most accessible markets. In fact, individual investors are able to trade currency at the same rate and in the same manner as large corporations, investment banks and hedge funds. In addition to these unique attributes, the FOREX is also a decentralized market, meaning there is no one physical location where traders go to complete their transactions; instead, they buy, sell and exchange currencies using a network of various devices, among which the Internet is probably the most important. Although the idea of trading money may seem strange and even far-fetched to some people, it is a vital part of the international economic and political spheres.

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