Currencies are mediums of exchange which facilitate the transfer of goods and services. Currencies can be either in a fixed exchange rate or floating exchange rate, depending on the regime. In a fixed exchange rate regime, a currency's value is tied to the value of another currency (usually U.S. Dollar), basket of currencies, or another measure of value. Fixed exchange rate regimes have been most notably applied in Asia, and very recently in China which will not allow its currency to appreciate more than a prespecified rate against the U.S. Dollar. In a floating exchange regime, a currency's value is allowed to freely change relative to others depending on economic and political factors.
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A variety of factors explain the movements of foreign currency exchange rates over the long term. Although rigid, formula based models work very well in explaining the currency movements in the short term, they fall short in predicting exchange rate levels over the long term. Currencies are noted for their long term trends and in this article, we cover the most important factors that determine the level of exchange rates. Balance of PaymentsIt's logical to think that a country that continues to import a lot more than it exports will have a weakening currency. Currently, the U.S. imports lots of goods from China because of their low cost. In order to return this trade relationship to "equilibrium", the U.S. Dollar needs to weaken versus the Chinese currency so that Chinese goods will be more expensive for the U.S. to import, thus decreasing demand. For this reason, China does not allow its currency to freely float versus the U.S. Dollar, but this example forms the basis for the balance of payment model, and is the key argument in why some people expect the U.S. Dollar to weaken versus other currencies. |
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The Foreign Exchange Market (FX or FOREX Market for short) refers to where currency trading takes place. It is the largest and most liquid market in the world hosting a variety of market participants. The major centers for trading are New York, London, and Tokyo which allow for trading to occur 24 hours a day (except weekends). Due to relatively small daily fluctuations in currency values and large trading volumes, the currency market makes use of extensive use of leverage. For example, one may only put $10,000 of capital to control the equivalent of $1,000,000 of currency. The overwhelming majority of all currency trades are purely speculative. The FX market is divided into levels of access with only the largest banking firms having access to razor sharp bid-ask spreads. Each bank may trade billions of dollars a day and prices are normally unavailable to those outside the inner circle. Other participants in the FX market include: commercial companies, central banks, hedge funds, investment management firms, and retail brokers. |
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