How does the exchange rate work?

How does the exchange rate work?

Before you are going to trade Forex it is important to understand how a foreign exchange market works. The foreign exchange rate is formed by the interaction of supply and demand.

The structure of the exchange rateHow does the exchange rate work?

With Forex you always trade currency pairs. This is quite logical as you need something to express the value of money. Relationships between two currency pairs are always listed as a ratio. Take EUR / USD for example, here you look at the amount of dollars you can buy with one euro.

When the rate of EUR / USD is 1:20 you get 1.20 dollars for one euro. The first currency in the ratio is called the base currency and is always one. The second number is called the quote currency and this number indicates how much of the alternative currency you get in return.

Tip: USD / EUR you can calculate by dividing the base currency by the quote currency. 1 / 1.2 = 0,833

How the rate moves

In case of a rising price line on a graph the base currency increase in value and the quote currency decreases in value. In case of a declining price line the value of base currency in the quote currency value and increase in value. Please note that the decline in EUR / USD does not necessarily mean that EUR / GBP is also falling, even the opposite may happen!

Counting with pips

In the vast majority of currency pairs a pip is the fourth digit after the decimal. So if you see EUR / GBP reads 1.1234, the fourth decimal or 0.0004 is the current pip value. When the price rises to 1.1235, the exchange rate moved up one pip and when the price rises to 1.1244 the rate moved up with 10 pips.

A major exception in this is the Japanese yen. In currency pairs with the Japanese yen the second number after the decimal is the pip value. At a rate of EUR / JPY 123.86 the second decimal number 0.06 is one pip and an increase to 124 would mean a rise of 14 pips.

Long and short

Ultimately, the only thing you are trading for is making profit. Estimating the direction of the price is an important part of this. In Forex you can both buy (go long) and sell (go short). When you go long you earn money when the price rises, and when you go short you earn money when the price falls.

A broker often applies a buying (bid) and selling (ask) price. The difference between the bid and ask price is the so-called spread. The spread makes up the transaction costs of the position and it is the broker’s source of income.