In finance, the exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies specifies how much one currency is worth in terms of the other. The foreign exchange market is one of the largest markets in the world. By some estimates, about USD 2 trillion worth of currency changes hands every day.
An exchange rate quotation is given by stating the number of units of a price currency that can be bought in terms of 1 unit currency.
Quotes using a country's home currency as the price currency are known as direct quotation or price quotation and are used by most countries.
Quotes using a country's home currency as the unit currency are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and Canada.
The exchange rate regime is the way a country manages its currency in respect to foreign currencies and the foreign exchange market. The basic types are a floating exchange rate, where the market dictates the movements of the exchange rate, a pegged float, where the central bank keeps the rate from deviating too far from a target band or value, and the pegged exchange rate, which ties the currency to another currency, mostly more widespread currencies such as the U.S. dollar or the euro.
Floating currency rates are the most common exchange rate regime today. For example, the Dollar, Euro, Yen, and British Pound all float. Exchange rates for such currencies are likely to change almost constantly as quoted on financial markets, mainly by banks, around the world.
Nominal and real currency rates
The nominal exchange rate is the rate at which an organization can trade the currency of one country for the currency of another.
The real exchange rate is the rate at which an organization can trade goods and services of one country for those of another.
Fluctuations in currency rates
A market based exchange rate will change whenever the values of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply (this does not mean people no longer want money, it just means they prefer holding their wealth in some other form, possibly another currency).
Increased demand for a currency is due to either an increased transaction demand for money, or an increased speculative demand for money. The transaction demand for money is highly correlated to the country's level of business activity, gross domestic product (GDP), and employment levels. The more people there are out of work, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions.
The speculative demand for money is much harder for a central bank to accommodate but they try to do this by adjusting interest rates. An investor may choose to buy a currency if the return (that is the interest rate) is high enough. The higher a country's interest rates, the greater the demand for that currency. It has been argued that currency speculation can undermine real economic growth, in particular since large currency speculators may deliberately create downward pressure on a currency in order to force that central bank to sell their currency to keep it stable (once this happens, the speculator can buy the currency back from the bank at a lower price, close out their position, and thereby take a profit).
In choosing what type of asset to hold, people are also concerned that the asset will retain its value in the future. A currency will tend to lose value, relative to other currencies, if the country's level of inflation is relatively higher, if the country's level of output is expected to decline, or if a country is troubled by political uncertainty.
Like the stock exchange, money can be made or lost on the foreign exchange market by investors and speculators buying and selling at the right times. Currencies can be traded at spot and foreign exchange options markets. The spot market represents current exchange rates, whereas options are derivatives of currency rates.