HOW DO EXCHANGE RATES FUNCTION?

If every country in the world used the same currency, world trade would be made much easier. But this is not the case: a Copenhagen beer producer wants to be paid in Danish “kroner”, and a Hong Kong shirtmaker wants to be paid in Hong Kong dollars.

Currencies, like other commodities such as beer and shirts, have a certain value. The only difference is that each currency's value is stated in terms of other currencies. French francs had a value in U.S. dollars, which have a value in British pounds, which have a value in Japanese yen. These exchange rates change every day and are constantly updated in banks and foreign exchange offices around the world.

The world's foreign exchange markets keep track of the values of all of the major currencies. As some increase in value, others decline. When a Euro goes up in value against the U.S. dollar, the dollar must go down against the Euro. At the same time, it may decline in value against the British pound. Foreign exchange is a constantly changing twenty-four-hour-a-day market with trading going on in hundreds of financial centers around the world, from Singapore to San Francisco and from Oslo to Buenos Aires.

These markets are all linked electronically. Banks and "Bureaus de Change" look at this global interbank market to set their daily rates, which are given to foreign travelers when they change their money abroad.

As anyone traveling abroad will notice, the exchange rate is slightly different if the customer is buying or selling any one particular currency. This spread between the "buy" and "sell" rates ensures that banks and exchange bureaus make a small profit every time one currency is changed into another. By exchanging money back and forth times, an indecisive traveler would-end up with nothing, after losing a few percentage points in spreads and commissions on each transaction.

How do the foreign exchange markets decide how much a currency is worth? Just like other markets, the foreign exchange market is subject to the laws of supply and demand. If enough traders want to buy U.S. dollars, its value will go up, i.e., it will take more of other currencies to buy dollars.

Foreign exchange prices are influenced by economic and political events and sometimes by the speculation of individual traders. Foreign exchange traders, like traders in grain or pork bellies, sometimes "bet" that a currency will increase in value. If interest rates fall in Tokyo, traders may rush to sell yen and buy dollars. If the Swedish economy looks strong, the krona may increase in value. If political turmoil threatens the Swedish economy, the krona may decline in value as investors sell them to buy what they perceive to be more stable currencies.

During periods of economic turmoil, the world often turns to a particular currency as a refuge. When political or social unrest threatens other currencies around the world, traders and investors sometimes rush to buy hard currencies like the U.S. dollar, which is expected to preserve its value in times of trouble.

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