Guide to Foreign Exchange Rates Key Terms

Understand currency trading by learning foreign exchange rates key terms

You can go a long way toward understanding forex trading and currency quotes by learning a few foreign exchange rates key terms. Although the foreign exchange market is the largest and one of the most complex markets in the world, investors and businesspeople must be familiar with how it works to make smart, effective international trades.

Perhaps the most important thing to remember when dealing with currency is that there is more than one foreign exchange rate. Governments, banks and trading agencies report a variety of rates that depend on different variables, including the time of the trade and inflation. In general, these rates are governed by the following rules:

1. Currency exchange rates can be based on trades made in the present or in the future.

2. Only real effective foreign exchange currency rates accounts are adjusted to take inflation into account.

3. Some central banks fix their countries' exchange rates, while others allow them to move up and down according to market demand.

Action Steps

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Take advantage of both the spot and the forward foreign exchange rates:

The spot exchange rate is the 'normal' exchange rate--it specifies the immediate or current value of a country's currency in terms of another. Interestingly, the forward exchange rate is a rate set during the current trading day, with payment agreed upon at a future date. Businesses and traders often use the forward exchange rate to protect themselves from a future drop in the value of their national currency by engaging in hedging and speculatory investing.

I recommend: InvestorWords.com maintains one of the Internet's largest glossaries of current foreign exchange rates definitions and other financial terms. You can also learn about forward and spot contracts from Wells Fargo, which offers a glossary of key international trading terms.

Beware the difference between nominal and real effective forex rates

Nominal exchange rates examine a country's balance of trade with other countries to determine the value it places on their currencies. However, these rates don't take inflation into account, so they can only approximate the price that consumers (including businesses) will pay for imported goods. The government attempts to fix this discrepancy by adjusting the rate for inflation, creating the real effective exchange rate, which reflects the actual price of goods at the consumer level.

I recommend: Although each country has its own methodology for calculating real effective exchange rates, you can learn how the U.S. determines them by visiting the website of the USDA Economic Research Service. This site also provides in-depth explanations of several exchange rate terms. The Consumer Price Index (CPI) and Producer Price Index (PPI) are also important factors in determining the real purchasing power of the dollar and two key terms you should be familiar with.

Know the significance of floating and fixed foreign exchange rates

Many countries with healthy financial systems allow their exchange rates to 'float' up and down as the demand for their currency increases or decreases in the forex market. Some countries, however, choose to 'peg' their exchange rates to some fixed value, tying their currency's value to that of another country (until 2005, China maintained such a policy.) While this may help developing countries achieve some financial success, it forces them to relinquish control of their domestic monetary policies, which can be dangerous in the long-run.