Forex Trading and the Exchange Rate

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Forex is a portmanteau of foreign currency and exchange. Foreign exchange is the process of changing one currency into another currency for a variety of reasons, usually for commerce, trading, or tourism. According to a recent triennial report from the Bank for International Settlements (a global bank for national central banks), the average was more than $5.1 trillion in daily forex trading volume.

What is Forex Trading?

Forex trading is the act of speculating the price movement of various assets on the foreign exchange market, with making a profit in mind. It is also known as currency trading, FX trading, or foreign exchange trading.

Generally speaking, forex trading involves exchanging one currency for another, or to put it differently buying one currency while simultaneously selling another.  As a day trader, you buy or sell currencies for the purpose of generating a return from the market’s movements.

Exchange Rate

Currencies are traded usually through a broker(or forex broker), a dealer, or a bank(institution) and are always traded in pairs. Every currency pair has a price called the exchange rate. An exchange rate is a price paid for one currency in exchange for another. It is this type of exchange that drives the forex market.

When you exchange US dollars for Euros, there are two currencies involved. For every fx transaction, you must exchange one currency for another. This is why the forex market uses currency pairs, so you can see the cost of one currency relative to another.

For example, EURUSD is the most traded currency pair in the world. The EURUSD price or exchange rate lets you know how many US dollars (USD) it takes to buy one euro (EUR).

 

Based on the information above, considering the exchange rate at the time is 1.1350, then 1 Euro would give 1.1350 US dollars in exchange.

Exchange Rates: Fixed vs Floating

Currency or fx prices can be differentiated into two main categories: fixed or floating rates.

A fixed (or otherwise known as pegged) rate is determined by governments and central banks. The rate is set against another major world currency, such as the US dollar, the Euro, or the Yen. To maintain a certain exchange rate, the government will buy and sell its own currency against the currency to which it is pegged.

A floating rate is determined by the open market through the supply and demand available in the global markets. Therefore, if the demand is high, the value will increase. If demand is low, this will subsequently lower the price and the exchange rate. Very often, technical and fundamental factors determine what investors and traders perceive is a fair exchange rate that is adjusted accordingly.

The currencies of most of the world’s major economies were allowed to float freely following the collapse of the Bretton Woods system between 1968 and 1973. Therefore, most exchange rates are not set but are determined by on-going trading activity in the world’s currency markets.

Henry Hicks
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