Exchange rate in forex

Jun 11 / VT Markets
Exchange rates underpin the entire forex market, and you’ll need to know how to view, read and understand these rates as you develop your trading skills. Learn more in our guide.

UNDERSTANDING EXCHANGE RATES IN FOREX

What is the exchange rate? The exchange rate in forex indicates how much of one currency is required to purchase a fixed amount — or one unit — of another. For example, it may require US$0.6 to purchase A$1, or it will require A$1.47 to purchase US$1. These values are subject to change.

Exchange rates are essentially the foundation of the forex — or foreign exchange — market. When you trade on this market, you will generally be working with a currency pair and speculating on the movement of the exchange rate between the currencies within this pair. One currency in the pair is the base currency — this is the ‘unit’ mentioned above. The other currency in the pair is the quote currency. The exchange rate is how much of the quote, or selling, currency is required to purchase one unit of the base, or buying, currency.

This is also important if you are trading with currency correlations . A currency correlation trade involves speculating of the relative movements of four currencies divided into two pairs. Understanding the exchange rate is critical for opening these more complex positions.

While the evolution of this exchange rate over time is what currency pair trading is based on, it is a factor in other trades too. Whether you are seeking to invest in a foreign market, or simply looking to make a currency trade ahead of an international trip, the exchange rate is something you’ll need to be aware of.

READING THE EXCHANGE RATE

The exchange rate is measured in pips. Pips in forex refer to small movements of price, which will be at the fourth decimal place for most currency pairs, or at the second decimal place for pairs with quote currencies that have smaller denominations such as the Japanese yen. Observing these pip movements will help you to understand which direction the exchange rate is heading.

So how do you read this rate? It doesn’t matter what platform or service you use; the rate will be expressed in the same way — as a decimal value.

Let’s examine this by looking at the above example. In this case, we can make a currency pair of USD/AUD — the United States dollar is the base currency, and the AUD is the quote currency. This pair would be represented as USD/AUD 1.47 – which means 1.47 units of the AUD are required to purchase one unit of the USD, or A$1.47 per US$1. 

Because the forex trading platform deals with a large number of different currencies from all over the world, the exchange rate will always be represented as a pair with the base and quote currencies both displayed. In other trading locations, such as at a physical exchange, you may only see a value for the quote currency. This is because it will be taken as given that the base currency is the local national currency.
HOW EXCHANGE RATES ARE DETERMINED
How is currency valued? How are exchange rates determined? These rates are influenced by a wide array of different factors, which combine to make forex trading a complex but exciting endeavour.

Supply and demand is arguably the most obvious factor. If more people are buying a particular currency, and the market supply is not increasing in line with this, then the price of this currency will increase relative to others. If the opposite happens, or if supply outstrips demand for another reason, the price will fall.

Geopolitical factors will also play a major part. The United Kingdom’s exit from the European Union led to a significant fall in the relative value of the British pound, for example. However, it’s difficult to predict these market movements — economic sanctions against the Russian Federation led many to predict a decline for the Russian rouble, but this currency instead rallied against other major global currencies such as the United States dollar.

In this sense, exchange rates are not so much ‘determined’ as they are ‘dictated’ by market forces. There is no central committee overseeing the forex market, and rises and falls happen spontaneously. Even with careful research and forecasting, there are no guarantees in the market, and the exchange rate in FX may not move in the way you expected it to.

FIXED AND FLOATING EXCHANGE RATES

To understand how exchange rates work, you need to recognise the difference between fixed and floating rates. As you learn how to trade forex and become more familiar with the market, you will notice that most currency pairs display a floating exchange rate. This means they are determined according to market forces. When supply and demand fluctuate, the rate of exchange in FX will fluctuate too.

Other currencies may not have a floating rate, but the rate will instead be fixed. This means the central bank of a particular country will peg the value of their own currency to that of another. The central bank achieves this by trading its own currency against its partner — usually the United States dollar but sometimes another form of currency. 

The Saudi Arabian riyal is an example of this and will retain the same fixed rate against the United States dollar. 

These currencies can still be used for speculation, as they are still subject to market forces. For instance, while the riyal will maintain the same value against the US dollar, it will fluctuate in relation to the European euro or the Japanese yen.

EXCHANGE RATES AND SPREADS

Trading on the forex market is not free, and brokers and trading platforms need to secure revenue to keep themselves profitable. This is where forex spreads come into play.

When you view a currency pair and assess the exchange rate, you will notice that the price to buy and the price to sell the pair are not the same. There will be a disparity between the bid price (the buying price) and the ask price (the selling price), which is known as the spread. 

Tighter spreads are more favourable for traders, as it reduces the cost associated with opening a position in the market. However, this spread may change over time in response to market forces, and this will have an impact on the cost of keeping each position open.

EXCHANGE RATES, LEVERAGE AND MARGINS

When you trade on the forex market, you will quickly encounter leverage and margins. Leverage in FX means borrowing money from the broker to supplement your own capital, and this will be expressed in a ratio. A position leveraged at 20:1, for instance, will involve borrowing $20 for every $1 of your own money you use to open the trade. Of course, this means the potential benefits of the forex trade increase significantly, but your potential losses increase too – this money will need to be paid back regardless of whether or not the trade is successful.

Margin trading works in a similar way, and you will still be borrowing money from the broker to supplement your own capital. However, the margin will be represented as a percentage. Opening a $1,000 position with a margin of 5% will require you to put up $50 of your own money, while the broker will make up the remaining $9,550. This is basically the same as using a 20:1 leverage to control a $1,000 trade. Again, the potential for profits increases, but so does the risk to the trader.

In both cases, you will incur a margin call if your available funds fall below the margin rate set by the broker. If this happens, you’ll need to close positions to bring your account back into line with requirements, or you’ll need to deposit funds directly. Failing to meet a margin call will result in positions being liquidated.

How does this relate to exchange rates? Well, it’s the movement of the exchange rate that drives the success of the trade. A movement of a few pips may not seem like much, but this can result in a significant rise or fall when leverage and margin trading is involved. If the exchange rate moves too far in an unexpected direction, a margin call may be issued. This means you need to take great care when working with these sorts of trades, implementing stop loss tools to provide additional protection.

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