By: Michael E. Martinez

Exchange rates are the official value of a country's monetary unit at a given date over a given period of time. It is expressed in units of local currency per U.S. Dollar and determined by international market forces. In finance, the exchange rate between two currencies specifies how much one currency is worth in terms of the other. For example, 120 Japanese Yen to the U.S. Dollar means that it is worth the same as a dollar. An exchange rate is also known as a foreign exchange rate or FX rate. The currency market or Foreign Exchange Market is the largest market in the world, about $2 trillion worth of currency changes hands everyday.

An exchange rate quote is given by stating the number of units of a price currency that can be bought in terms of one unit currency. Quotes using a country's home currency are known as direct quotes or price quotes. Quotes using a country's home currency as the unit currency are known as indirect quotes or quantity quotes and are used in British newspapers and are also used in Australia, New Zealand and Canada. If a unit currency is strengthening then the exchange rate number increases, if the price currency is strengthening, the exchange rate number decreases. If a currency is free-floating its exchange rate is allowed to vary against that of other currencies.

Exchange rates for free-floating currencies are likely to change almost constantly, if the value of the currency is "pegged", its value is maintained by the government in question. A market based exchange rate will change whether the value of either of the two component currencies change. A currency will tend to become more valuable whenever there is a greater demand for it. It becomes less valuable whenever demand becomes less, this doesn't mean that people no longer want money, it just means they prefer holding their wealth in another form. The transaction demand for money is highly correlated to the country's level of business activity, GDP and employment levels. The more people are out of work, the less the public will spend on goods and services. Banks usually have little difficulty adjusting the available money supply to go along with changes in the demand for money due to business transactions.

Like the stock exchanges, money can be made or lost on the foreign exchange market by investors and speculators buying and selling at the right times. Currencies can be traded at foreign exchange options markets. The spot market represents current exchange rates. In choosing what type of asset to hold, people want to be sure that the asset will retain its value in the future. It's obvious that people will not be interested in a currency if they think it will devalue. A currency will tend to loose value relative to other currencies; if the country's level of inflation is higher or if a country is troubled by political uncertainty.