Let’s pick up where we left off in the last article on the basic happenings of the foreign exchange market. We mentioned that people buy and sell currencies for one another, but we need to establish how these prices are set.
In forex, prices for currencies are relative to one another.
How forex prices work
It’s hard to imagine giving a price for a currency in another currency. That just doesn’t make sense; it’s much easier to understand currency value as what we can exchange it for.
We can easily know that 1.25 US Dollars is enough to buy a soda–a Coca-Cola. However, how can traders know that $1.25 is equal to 1 Euro, .80 Pounds, or 10 Mexican Pesos?
It’s the economy!
In many ways, the value of each currency is tied to the performance of the economy it represents.
When the American economy is performing well, the dollar is likely to rise in value against other currencies. Thus, holding dollars is very much like investing in every person, company, and government in America, since the value of the dollar is dependent on everyone’s success.
Isn’t it great we all benefit from the success of everyone else? A strong economy almost always leads to a stronger national currency.
Taking that point to its logical conclusion, it would make sense that when the US economy is strong, so too is the dollar. Thus, the dollar’s value rises against other, weaker economies. A new perspective: if the US economy is growing and Mexico was experiencing a recession, the US dollar would likely be a stronger investment than the Mexican Peso. The market would reflect this, and it would take more Pesos to buy a dollar.
Investors who notice this trend can profit by speculating on the changes in currency values. If the dollar is soon to rise against the Peso, a trader could exchange Pesos for dollars through a currency broker. This trader would make a profit after the exchange rates change in his or her favor.
For example: Assume that we borrow 10 Mexican Pesos and trade them for 1 US Dollar.
If the currency rates change so that now it takes 11 Pesos to buy 1 US Dollar, we can exchange our US Dollar for 11 pesos, pay back the 10 pesos we borrowed, and enjoy a 1 peso profit. That one peso profit, at the current exchange rate of 11:1, is worth $.09. We made a 9% return on our dollars!
This is the very simple core of the foreign exchange market. When traders speak of buying and selling currencies, they’re really just talking about swapping one currency for another to make a profit. Of course, the full story is slightly more complicated, but keep reading and we’ll share all the nitty-gritty details.
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