Forex Exchange Rate - How Does It Get Calculated?

In the Forex market the value of two separate currencies and how they relate to one another is what is known as the Forex exchange rate. Usually the Forex rate is how much of one currency is needed to buy a unit of another. Knowing the basics regarding the Forex exchange can help you get started in understanding it even better.

Just to give you an example of how the Foreign exchange rate can work and to help you better understands it we can compare the United States dollar with the Japanese yen. Let's say that on a certain day the US dollar is able to buy one hundred and ten Japanese yens, this would indicate that the exchange rate for that day is 1:110 or a one to one hundred and ten ratio. This ratio in the exchange rate is also known as pairing. When you take it vice versa you can use it to indicate how many US dollars a single unit of Japanese yen can buy. Another term that is used in the Foreign exchange rate is 'cross rates'. This term however is only used when it does not involve US dollars; it is only used when relating two foreign currencies.

A few other terms used in the Forex exchange are pips or basis points, which are actually two terms used for the same thing. These terms are used to indicate Forex rates that are calculated up to four decimal points and whether or not these are negative or positive movements. An example of this would be if you were to exchange euros with yen at a value of 135.1030, but then the euro rate goes up to 135.1035, it is called a five-pip improvement.

In using the Forex exchange rate you are required to use two currencies and this means they are quoted as 'two tier' rates. Also in the Forex market its price basis is called a bid/ask. Using the previous ratio between the yen and the US dollar in the Forex market, if this trade is made it is called a ten pip 'spread' and is secured. This term means it indicates the difference between the buying and actual selling price. A lot of things can change the spread and affect it. These things include market conditions and traders' instincts about the strength of certain currencies, which can fluctuate greatly from day to day. One thing you should remember however when it comes to the Forex is that only Forex traders who are licensed can access official quoted rates. This means therefore that smaller investors may not receive their currency at a very good rate, because they usually receive them from commercial banks.

One last thing concerning the Forex exchange rate is that it is independently determined. This is why it thrives so well, because solely buyers and sellers and their supply and demand of certain currencies determine it. In the end individual governments and banks cannot decide the values.

The Exchange Rate: Dollars for Yen or Yen for Dollars, Which Way is It?

Forex exchange-rate index is designed to measure how, over time, movements in the dollar will affect U.S. imports and exports. And to do this well, Forex index must also take account of any differences between the rate of inflation in the United States and the rates of inflation in other countries. Suppose that the rate of inflation were 10 percent a year in the United States but only 3 percent a year in Germany. The buying power of the dollar in the United States is falling 7 percent a year faster than the buying power of the German mark.
Now suppose that Forex exchange rate of the dollar declined by 7 percent from one year to the next against the mark. Then German buyers would be getting 7 percent more dollars for their marks; but the decline in the exchange rate would be exactly undone by the greater increase in prices in the United States than in Germany. The number of Mercedes that it took to trade for one Boeing 757 would be the same in the two years. (At least, this would be true on average for many goods.) This means that, when a change in Forex exchange rate simply compensates for differences in inflation rates, the relative prices of U.S. imports (from Germany) and U.S. exports (to Germany) do not change.

Readers let us notify: international Forex trade economists do it differently. One of the most confusing concepts in economics is the way in which Forex rate of exchange between two currencies should be expressed. As we indicate in the article, we choose to express the rate as the number of units of foreign currency that can be purchased with one dollar (e.g., let’s say the yen is trading at 130 yen to the dollar). This approach is commonly used in the media and it squares with the intuitive idea of appreciation or devaluation of the dollar. When Forex exchange as we have defined it goes up (e.g., from 100 yen to 120 yen), the dollar buys more foreign currency – the dollar has appreciated. When Forex exchange rate goes down (e.g., from 100 yen to 90 yen), the dollar buys less foreign currency – the dollar has depreciated.

Unfortunately, this approach is the inverse of the concept that international trade economists focus on when they describe Forex foreign-exchange markets. They define Forex exchange rate in terms of the price of foreign exchange, so the yen to dollar exchange rate is the cost of purchasing one yen with dollars. If Forex exchange rate in our terms is equal to 100 yen to the dollar, the inverse would be $0,01 (one cent) per yen. If the dollar appreciates, from 100 yen to 120 yen to the dollar (dollar purchases more yen), then Forex exchange rate, expressed as the cost of yen, declines in dollar terms, in this example dropping from $0,01 to $0,0083.

The appreciating dollar means that yen purchased in foreign exchange Forex markets are now cheaper to buy with dollars, exactly the concept that trade economists wish to show. But it also means that their definition of the Forex dollar-exchange rate falls when the dollar appreciates! This is very confusing and so we define Forex exchange rate as yen per dollar, rather than dollars per yen.