Forex Basics: Exchange Rates Tutorial

Profits are made and lost in the foreign exchange market, or ‘Forex’, due to fluctuations in the exchange rate. This fact may seem like common knowledge, but how exchange rates are determined should not be taken for granted.

In fact, there is a very rich history behind the concept of the exchange rate, and it is important that you understand why things came to be the way they are, as well as how to capitalize on that knowledge.

This quick tutorial on exchange rates will help you do just that.

First, let’s look at the simplest definition of an exchange rate. An exchange rate is the value of one currency in relation to another. If one US dollar is worth Canadian $1.20, then the exchange rate is 1:1.2 or 1.2 for the CAD/USD currency pair.

However, what does this really mean? Why can one currency be worth more than another and who decides?

If you look back to the early part of the 20th century, you’ll remember that most of the world’s currencies were based on precious metals, such as silver and gold.

Before, the United States followed the “gold standard”, which “fixed” the dollar at the price of 1 ounce of gold. All other currencies were then ‘pegged’ to the dollar and allowed to fluctuate in either direction by a margin of no more than 1 percent.

This exchange rate, while allowing for minor fluctuations, was considered a “fixed exchange rate.”

Now, fast forward to the second half of the century, and you’ll find that the ‘gold standard’ has been phased out, along with the fixed exchange rate model. Instead, the forex market now operates primarily on a ‘floating exchange rate’.

Fluctuating exchange rates are governed by the market forces of supply and demand. If the demand for a currency exceeds the supply, the exchange rate (and value) of that currency will increase.

Similarly, if the supply of a currency exceeds the market demand, the value of that currency (and its exchange rate) will fall.

We see this happen today with the US dollar. To keep up with government spending, the federal reserve prints more and more dollars and then sells it to other countries as ‘debt’.

Market forces that previously gave strength to the dollar, such as oil exports and US dollar-denominated oil transactions, have eroded. Thus, we find not only the weakening dollar exchange rate, but also the exchange rates of many of our closest trading partners.

The Japanese yen, for example, has fallen even more than the dollar. Part of this is due to a general slump in the Asian market, but it is also related to the fact that much of Japan’s economic growth at the turn of the last century depended on exports to the United States.

This is just one example of how market forces affect exchange rates, but it is useful for examining some of the factors involved in rate fluctuations.

If you want a tutorial on real world exchange rates, I recommend opening a demo trading account with an online broker. Do a few test trades to get a feel for things and take note of the current exchange rates.

Then be sure to keep up with financial and world news, and see if you can spot the relationships between big announcements and rate fluctuations!