The Currency Market and How it Works

Many news outlets report on currencies strengthening or weakening due to some factor or other. We’re told that Sterling has rocketed, or the Dollar has slumped, or the South African Rand is holding its ground, but it isn’t always clear whether this is good news or bad news.

Currency news articles also tend to talk about things like interest rates, inflation and monetary policy tightening outlooks. They might say that hawks are talking like doves or that bears have turned into bulls.

The question has to be asked: what on earth are they talking about?

If you find the whole thing a little bit baffling, here’s a quick guide to understanding currency markets news.

Exchange rates are simply the market value of one currency compared to another. So, for example, 1 Pound may be worth 1.4 Dollars. That means, in theory, the shiny Pound coin in your pocket would buy you 1 US Dollar and 40 cents. Exchange rates are expressed as a ratio between two currencies. Each currency is assigned a three-letter code, known as its ISO code. So, for example, the Pound (GBP) to South African Rand (ZAR) exchange rate would be expressed as GBP/ZAR. They change constantly, with the value of one currency relative to another changing in reaction to a host of factors – not all of them economic – including political stability, conflict, social issues and even the weather.

If an exchange rate is ‘strong’ it means that is has risen in comparison to recent or historic levels. Making a currency transfer at a stronger exchange rate means you’ll be able to buy more of the currency you want with the currency you have than you would have when the exchange rate was weaker.

The reason interest rates are so important to Forex traders is that they naturally want to invest their money in countries where it will earn the best rate of interest. So, signs that a country is about to raise its interest rates can cause an inflow of money from the currency markets, while indications that interest rates are about to be cut have the opposite effect.

Today’s Forex market is unregulated, with money free (more or less) to move anywhere around the world. There are no clearing houses or arbitration panels, so perhaps unsurprisingly it attracts speculative investors. Speculative investors have one aim: to make money by trading. Because of this, the vast majority of money whizzing around the world between foreign exchanges is speculative in nature.

Originally, all currency was backed by something of value like a precious metal. Sterling was, at one point, backed by silver while many other countries were backed by gold, a system known as the Gold Standard. In this way, a country’s currency was directly indexed to how much physical gold resided in their national coffers, and this system persisted until the Great Depression, when countries including Great Britain were forced to abandon it following speculative attacks.

Instead of being backed by precious metals, currencies around the world instead became known as ‘fiat’ currencies. The word ‘Fiat’ means ‘let it be done’ in Latin, and in practice this means the value of a currency is held simply in the fact that the issuing government says it has value. The effect that fiat currency has had on the foreign exchange markets has been dramatic, it effectively means that the value of a currency could be zero, or at the other end of the scale, a single unit of it could be worth a fortune!

A currency broker is a specialist company who buys and sells foreign currency on behalf of private or corporate clients. a good currency broker will know the Forex market inside out and will be able to provide expert guidance about current and future exchange rate movements.

This has only been a basic introduction to the complicated world of currency exchange but I hope it helps you to understand, a bit better, how it works.

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