How is the Exchange Rate determined?

[quentinc]

I've heard it explained before, but it was kind of fuzzy. I was wondering if someone could find a good link or explain the dynamics used in determining the exchange rate between currencies.

[Pack87Man]

I've heard it explained before, but it was kind of fuzzy. I was wondering if someone could find a good link or explain the dynamics used in determining the exchange rate between currencies.
The exchange rate has a couple different things involved. The first thing you need to compare are the relative interest rates. You figure out what you are going to get out of each one, and that's used to figure out the exchange rate. Another thing is called exchange rate parity. That means you can't make money by routing through another currency. For instance if the pound was worth $2 and the Euro was worth $1.30, that would make the pound cost 2/1.3, or 1.54 Euros. That's why when one currency moves against another, every other one has to move, as well. When this currency is the dollar, the effect is more pronounced because for many currencies, you have to trade through the dollar.

[obie]

In super-simple mode, it's determined by supply and demand. There are currency exchange markets all over the world where financial experts trade one currency for another based on the supplies that the sellers have on hand, and the demand for goods that the buyers want to buy in that currency (usually equities / debt).

For example, here are the bid / ask prices for US dollars against a variety of other currencies:
http://www.fxstreet.com/nou/dolargran.asp

Forex trading is very different from securities trading, though, because everything has to be in relation to everything else. If Currency A = Currency B and Currency B = Currency C, then Currency A must = Currency C at all times. Seems simple in theory but any change in one currency relationship has to be reflected (almost) instantaneously in every other relationship on the board, or else you'd easily be able to get into a cycle of trading A for B, B for C, and then C for A over and over and making a profit on every cycle.

[billf]

Its really a market like the stock market or anything else. Factors such as relative interest rates will play a role, but its not the only factor. Basically, the amount of a currancy demanded determines its exchange rate versus another. The flow of goods and services between countries will affect supply and demand as well because you need to pay for a country's goods in a country's currancy. For instance, if I'm an importer of cars and place an order for 500 BMWs, I need to esablish an account with the required amount of Euros to pay for them. There are may ways to do this to hedge and save money, but this demand for Euros will affect the exchange rate.

A country's central bank can also affect the exchnage rate by tightening or loosening the money supply. A looser money supply means more currency is in circulation against another. The par value should fall and the cost of goods in the country who's currency falls in value falls against another country's stimulating exports. Other countries like China will artificially create an exchange rate by pegging the currency to anothers. China keeps its currency pegged below the dollar to make its exports attractive.

Another thing will be speculation and arbitrage. You might have a hunch that one currancy will move one way or another so you buy a stake of, say, Euros that support that hunch. This will have a small effect on the exchange rate. Another effect will be arbitrage. Not every currency will float at the same value relative to all others at the same time because the dynamics between one economy and others will be different. One can take advantages of small differences between currency markets and currencies to effect exchange rates and to make money. Arbitrage will eventually even the market out and normalize rates between currencies. For instance if a currency fallls against the Pound before falling against the Euro, you can get your Pounds by buying Euros first which will move the price of Pounds in Euros. It isn't possible for a change in one rate to affect others right away. Banks and exchange traders make tidy sums from arbitrage between currencies and between currency markets. A dollar can trade at one price in NY and at another in Tokyo against any currency. If you find those subtle differences in an instance before they shift, you can save millions on a large foreign exchange. This is pretty much what the money market is.

There isn't anything to back currencies anymore so rates float on a number of variables. During the gold and silver standards the value of those metals determined the exchange rates. Now, that isn't the case. Its a combination of an economy's strength and the whims of the market forces.

[Pack87Man]

Many countries have monetary policies aimed at keeping their currencies normal. The US is not one of them (we keep our monetary policy aimed at combating inflation). Japan is the most notable of these, as they'd really prefer to have a fixed currency, but since the yen is so important and trades so much, it's really impossible.