Most of us who have not heard of clich situation that any corporation involved in foreign trade in a big way incurring huge losses on account of currency differences can hardly make sense of such a situation. In this article, I will go about explaining the basics of differences in various currencies in no nonsense and no jargonized simple language.
Different currencies command different prices depending on their purchasing powers decided by market forces, to put it rather simplistically. In actual practice this is a significantly complicated situation and process like a country's economic progress and foreign trade will have major bearing on the instant price.
Now, for a demonstration, let us see how much a US Dollar can buy/value in Europe and particularly in UK. We know beforehand that 1 US Dollar trades around 0.5136 GBP. This means that for what costs 0.51 Pounds one has to pay a full US Dollar. In other words, you will get roughly 2 US Dollars for every GBP. But this difference continuously fluctuates by nature, sometimes trending upwards and sometimes the other way. This difference arises fundamentally out of economic disparities between the two countries in trading lock but not essentially so.
Let us see how such a situation can arise which leads to difference in the currencies. When European Union brought to force the Euro, initially its value was set on par with the US Dollar, essentially based on the assumption that the economic mights of both European Union and United States were on par so that the trading values match between themselves and individually with their trading partners the world over.
As time progressed, US went through several unexpected turn of events which lead to federal funding of their budgetary and trading deficits. Domestic inflation meant that Americans spend more for the same service and goods which was not the case with their European counterparts.
But the same id not good for Japanese Yen which was trading at around 200 per US Dollar some twenty years ago is currently valued at 120 yens. This can straightly be attributed to the rise of Japanese economy vis a vis the American Economy.
The early attempts in the mid 1940s through Bretton Woods Agreement to standardize forex values were using gold for exchange. This was by fixing the exchange value of gold at US$ 35 per ounce. But again as the market forces would have it, this could not sustain for long before it was repealed.
What this means to a forex trader is longer the holding greater is the exposure to risk.
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