Almost every country has its own unique currency. The trend towards regional currencies such as the Euro is in its infancy. This trend could eventually lead to a single global currency, but until then a mechanism is needed to convert one currency to another to facilitate international trade. The foreign exchange or Forex market is one of the largest markets in the world with daily transactions exceeding $3.2 US trillion. The Forex exchange rate is the price of one currency against another. At the time of writing, 1.00 USD is valued at 0.508348 GBP or 0.674400 EUR.
Exchange rates between two currencies may be either floating or pegged. The West or the First World generally adhere to the 1971 Smithsonian agreements in which market forces rather than governments – are the major determinants of a currency’s value. The price of each currency is determined by the laws of supply and demand. The exchange rate for each currency moves towards an equilibrium at which price parity occurs.
This effect of this system on the exchange rate is that that the value of any two currencies against one-another will change from one moment to the next. For practical purposes banks and other providers of foreign exchange will often quote a rate for a day or similar time period.
Forex traders derive income by quoting two rates for each foreign currency a buying price and a selling price. Commission is usually charged as a percentage of the value of the transaction.
The free market system for currencies means that traders may buy and sell on a speculative basis, and some major exchange rate fluctuations have been blamed on currency speculators. A spectacular example of this was the dramatic fall of the South African rand in 2001 against the dollar. The rand lost about half of its value against other currencies during that year, but the following year became the world’s best performing currency regaining all of its losses.
Not all countries subscribe to the floating mechanism. Some countries have a currency that is pegged to the US dollar. Some countries have opted to use the US dollar as their currency in place of their own. China has become a major player in the world economy flooding the world with low cost goods.
The Chinese exchange rate is pegged to the US dollar. Many would argue that this exchange rate is artificial. The level at which the exchange rate is pegged allows for Chinese goods to be exported at extremely competitive prices while making imported goods expensive to the Chinese.
Before 1971 most currencies were pegged to the US dollar. Some countries continue to insist on a fixed exchange rate. While this may prevent short term fluctuations in the currency, changes in the purchasing power parity’ are not reflected in the rate. A robust black market’ for the currency often springs up offering rates that are more market related.