How Are Exchange Rates Calculated?

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International currencies are traded on a 24-hour basis around the world. Currencies trade over-the-counter rather than on exchanges like the New York Stock Exchange. Exchange rates, therefore, are constantly in flux. Banks or other businesses that exchange currencies for travelers and businesses rely on this trading to set their daily exchange rates. International traders can lock in rates when contracts are signed.

Forex Trading Begins Daily in Sydney

  • The foreign exchange markets trade about US$4 trillion a day in currency buying and selling, according to the Bank for International Settlements. Because of the nearly constant activity (the exchanges are only closed for a 24-hour period over the weekend), the very high volume, and the global scale of currency trading, foreign exchange---or Forex---is considered one of the most transparent markets in the world.

Supply and Demand Is Key to Foreign Exchange Rates

  • The value of currencies is based on simple principles of supply and demand. In general, foreign currency traders move toward currencies whose economies are thriving, where interest rates are high, and where both business and political environments are stable. Economic uncertainty sends currency traders running for safe havens, which has traditionally included the U.S. dollar. When economic times are booming, currency traders are more willing to take risks on emerging economies, such as South America, Africa or Asia.

Central Banks Can Manipulate Exchange Rates

  • Central banks can intervene to keep their currencies from either dropping too low or soaring too high. A central bank, like the U.S. Federal Reserve or the Bank of England, may not want their currency to be so high that it makes the country's exports too expensive on world markets. In that case, they may release dollars or pounds into the foreign exchange market to put downward pressure on the currency. Alternatively, a central bank may buy its own currency to take it out of the market and push its value higher.

Forex Trading Growing Rapidly

  • Foreign exchange trading has grown rapidly since 2000, according to the Bank for International Settlements based in Basel, Switzerland. Much of this increase has come from increased activity in Forex trading among large institutional traders such as hedge funds and pension funds. However, more and more individuals are trading currencies with the growth of online trading programs. However, interbank trading still accounts for the majority of activity on foreign exchanges and dominates the markets.

Trades Listed in Currency Pairs

  • Among the major currencies traded are the U.S. dollar (USD), the Euro (EUR), the British Pound (GBP), the Swiss franc (CHF), the Japanese Yen (JPY), and the Australian (AUD), New Zealand (NZD) and Canadian (CAD) dollars. Trades are listed according to a standard convention using these three-letter abbreviations. For example, USD/JPY 0.90 indicates that one U.S. dollar will purchase 0.90 Japanese Yen.

References

  • Photo Credit World Currency Trading Sets Exchange Rates
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