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Exchange Rates - What are they and how are they calculated?

Exchange Rates - What are they and how are they calculated?
Published:   12 Dec at 9 AM

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As any seasoned traveller
or holidaymaker will no doubt have already noticed, the currency exchange
rates very rarely stay static and can often fluctuate greatly during
the day. Many people make money from these daily fluctuations which
is most commonly described as Forex trading which involves the buying
and selling of different currencies as their value fluctuates. One thing
that few understand however is how these currency rates are actually
defined to start with. For example, who makes the decision on how much
the pound is worth in comparison to the united states dollar? And why
do these rates go up and down rather than just staying at a constant

To quickest way of
describing the way exchange rates fluctuate would be to look at what
is called the purchasing power parity. This is the theory that the exchange
rate would reflect the cost of certain goods in the each of the two
countries, An example of purchasing power parity would be to think of
it as a loaf of bread which costs $2 in America and £1 in the United
Kingdom. Using the purchasing power parity logic, it would see the £1
as being worth $2 and obviously then $1 being worth 50p. However, this
is the very simplest way of looking at it and the reality is that it
involves much more work and extensive calculations.

The daily fluctuations
of a currency are usually based on the supply and demand for that particular
currency. For example, if the demand for the currency increases and
the supply remains the same or decreases, the value of the currency
would go up, as with anything. On the other hand if there are more people
looking to try and sell and fewer trying to purchase, the value of the
currency will drop.

There are a variety
of reasons that can affect the demand for a particular currency the
primary one being the need for a certain currency for a transaction
purpose. For example, if a particular individual lives in England but
wants to purchase something from the United States, they would need
US dollars in order to make this purchase. Millions of these transactions,
often quite small, happen every single day and these can often affect
on the value of the currencies.

Investors also have
an affect because the traders who look to buy and sell currencies for
profit account for a significant proportion of the people involved in
the foreign exchange market. The market trades $4trillion each day so
this is a big market and most traders will look to make similar transactions.
For example, if there is an economic announcement that encourages traders
to purchase one particular currency, that currency will rise in value
as the demand rises. So as you can see, the value of a currency is predominantly
based on the supply and demand and how this affects the different areas
of currency trading.

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