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Currency Trading – How the Value of a Currency Is Determined
Have you ever encountered these questions from your spouse, relatives and friends?
- “Which currency will go up? »
- “What currency should I buy now?”
- “I currently hold Australian dollars. Should I sell them now or keep them? »
This list is by no means exhaustive, but these are real questions that I have received from different people in the past.
In this article, I go back to the basics of Forex trading and discuss how the value of a currency is determined. If you are new to Forex, we hope you find the discussion below helpful. If you are already an experienced Forex trader, I hope you will still benefit from my sharing.
Currency is always traded in pairs
Believe it or not, there is no answer to the question”which currency will go up?“The reason for this is that currency is always traded in pairs. I’m sure most of you have been on holiday abroad before. Think back to your last trip abroad. Did you use your home currency to exchange the currency of the country you were visiting based on the quote from your currency exchange?You made a Forex transaction.Essentially you bought the currency of the country you were visiting and sold your home currency .
As you can see, a Forex quote is always derived from two currencies. Let’s use Euro (“USD“) and US dollars (“USD“) as an example. Suppose EUR/USD is now at 1.2500. This means that for every 100 EUR we can trade for 125 USD. Conversely, for every 100 USD , we can exchange for 80 EUR.
A currency pair is a fraction
A currency pair can also be thought of as a fraction. This means that we can use mathematics to explain the movement of a currency pair. I have found this method very useful whenever I need to explain this concept to novice Forex traders.
Suppose C = A/B. The value of C will increase if any of the following events occur:
- when A increases but B remains constant;
- when A remains constant but B decreases; or
- when A goes up and B goes down at the same time.
Now, if A is EUR and B is USD, the value of EUR/USD will increase if one of the following occurs:
- when the EUR strengthens but the USD remains constant;
- when the EUR remains constant but the USD weakens; or
- when the EUR strengthens and the USD weakens at the same time.
Now, I hope you know how to properly ask your next Forex question. Instead of asking the questionwhich currency will go up?“, the right question to ask is”what currency pair will go upAt any time, we assess the relative strength or weakness of one currency against the other currency.
Use the law of supply and demand to explain the relative strength or weakness of one currency against the other currency
The law of supply and demand in economics is useful in explaining the relative strength or weakness of one currency against the other currency. Consider the following scenarios. In both scenarios, we will assume that the money supply in country B remains stable.
Country A decides to increase the interest rate to control the rise in the inflation rate. Generally speaking, when interest rates rise, there will be an increase in demand for the currency. In this case, if the currency pair in question is expressed in A/B, we would expect the value of this pair to increase.
Country A decides to increase the money supply in order to stimulate the economy and hopefully this will result in increased business and consumer spending. In this case, if the currency pair in question is expressed in A/B terms, we would expect the value of this pair to fall.
Please keep in mind that the above discussion has been simplified primarily for the benefit of novice Forex traders. The world works in a much more complex way, which means that many factors must be factored into this discussion. This deserves the space of another article in the future.
I hope most novice Forex traders now have a better understanding of how to ask their next Forex question. At least they should know that the right question to ask is “which currency pair will go up?” and not “which currency will go up?“
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