Forex Trading Tutorial: Role of the Exchange Rate
What is the Forex? | History of Forex Trading | Forex Market Background | Advantages of Forex Trading | Who Are Forex Market Participants? | Role of the Exchange Rate | Types of Orders | Payment and Settlement Systems | Exchange Rate Determination
  
Role of the Exchange Rate
The exchange rate is a price—the number of units of one nation’s currency that must be surrendered in order to acquire one unit of another nation’s currency. There are scores of “exchange rates” for the U.S. dollar. In the spot market, there is an exchange rate for every other national currency traded in that market, as well as for various composite currencies or constructed monetary units such as the International Monetary Fund’s “SDR,” the European Monetary Union’s “ECU,” and beginning in 1999, the “euro.” There are also various “trade-weighted” or “effective” rates designed to show a currency’s movements against an average of various other currencies (see Box 2-1). Quite apart from the spot rates, there are additional exchange rates for other delivery dates, in the forward markets. Accordingly, although we talk about the dollar exchange rate in the market, and it is useful to do so, there is no single, or unique dollar exchange rate in the market, just as there is no unique dollar interest rate in the market.
A market price is determined by the interaction of buyers and sellers in that market, and a market exchange rate between two currencies is determined by the interaction of the official and private participants in the foreign exchange rate market. For a currency with an exchange rate that is fixed, or set by the monetary authorities, the central bank or another official body is a key participant in the market, standing ready to buy or sell the currency as necessary to maintain the authorized pegged rate or range.But in the United States, where the authorities do not intervene in the foreign exchange market on a continuous basis to influence the exchange rate, market participation is made up of individuals, nonfinancial firms, banks, official bodies, and other private institutions from all over the world that are buying and selling dollars at that particular time.
The participants in the foreign exchange market are thus a heterogeneous group. Some of the buyers and sellers may be involved in the “goods” market, conducting international transactions for the purchase or sale of merchandise. Some may be engaged in “direct investment” in plant and equipment, or in “portfolio investment,” dealing across borders in stocks and bonds and other financial assets, while others may be in the “money market,” trading short-term debt instruments internationally. The various investors, hedgers, and speculators may be focused on any time period, from a few minutes to several years. But, whether official or private, and whether their motive be investing, hedging, speculating, arbitraging, paying for imports, or seeking to influence the rate, they are all part of the aggregate demand for and supply of the currencies involved, and they all play a role in determining the market exchange rate at that instant.
Given the diverse views, interests, and time frames of the participants, predicting the future course of exchange rates is a particularly complex and uncertain business.
At the same time, since the exchange rate influences such a vast array of participants and business decisions, it is a pervasive and singularly important price in an open economy, influencing consumer prices, investment decisions, interest rates, economic growth, the location of industry, and much else. The role of the foreign exchange market in the determination of that price is critically important. 
What is the Forex? | History of Forex Trading | Forex Market Background | Advantages of Forex Trading | Who Are Forex Market Participants? | Role of the Exchange Rate | Types of Orders | Payment and Settlement Systems | Exchange Rate Determination
|
