What the heck is an exchange rate?

The exchange rate refers to the relative worth of one type of currency against another. To make it very simple for you, let's use an exchange rate with which you are already familiar - the exchange rate of dollars to dimes. Suppose you have 10 one dollar bills. You know that each of those dollar bills is worth 10 dimes. You could, if you wanted, go to the bank - or the corner store - and ask to exchange your 10 dollar bills for 100 dimes. The exchange rate would be expressed as DOL/DIM=.10 or DIM/DOL=10. In other words, you can exchange one dollar for 10 dimes or 10 dimes for one dollar.

The same holds true when you expand the definition to include foreign currencies. Instead of dollars and dimes, your dealing with Euros, yen, pounds and francs. EUR/USD=1.1023 means that each euro is worth $1.1023 (yes, in forex we go to four decimal points because of the large volume of trading). In reverse, that would be expressed as USD/EUR=.9071. In other words, if you want to trade US dollars for Euros, it will cost you $1,102.30 to get 1000 Euros.

But exchange rates move up and down! How does that work?

Let's go back to our dollars and dimes. Let's say that your corner store has decided that from now on, it will only accept payment in dimes. If you want to buy a gallon of milk there, your dollar bills are now worthless. In order to buy that gallon, you're going to have to find someone to give you 30 dimes for your three dollars. That works out just fine - until there's a shortage of dimes in the neighborhood. You go to your brother, whose been tossing all his change into a bucket for the last five years and tell him, "I'll give you three dollar bills for 27 dimes because I need $2.70 to buy a gallon of milk."

Get Your FREE 7-Part Stock Investing Kit While Supplies Last!

You've just effectively changed the currency exchange rate from DOL/DIM=.10 to DOL/DIM=.11. That means every dollar is now worth 11 dimes instead of ten - and if you want to buy $100 worth of dimes, you'll get 90 dimes, not 100.

The same thing happens in the international currency market. If you want to buy goods in Japan, you need to trade with Japanese money. If all you have is dollars, then you need to exchange your dollars for yen. If lots of people are trying to buy yen at the same time, then you're going to end up paying (exchanging) more dollars for less yen - and the products that you're buying cost you more.

So why would people want to buy more yen?

When a country's economy is strong, people know that they'll make more money if they invest in businesses and products in that country. In order to buy products or invest money there, they need to exchange their currency for that country's currency. If there's a rumor that a major industry in that country is about to fail, people will want to get out - and will start trading in their yen for dollars or Euros or Aussies - whichever is the best exchange rate you can get.

So it's all about supply and demand?

There are a couple of other factors that influence exchange rates. One of those is the interest rate. When you hold currency, you earn interest in that country's currency at their prevailing rate. If the interest rate is higher for yen than for dollars, then people will trade in their dollars for yen in order to earn a higher rate. A second factor is the inflation rate. When the inflation rate in a country is high, people don't want to hold that country's currency since the value of the money is going down. Likewise, if the inflation rate is low, people are more likely to want the country's currency because the value isn't expected to go down.

One other important factor in the exchange rate is trade with other countries. If world prices for a country's exports go up in relation to their imports, they'll be making more on what they sell than they are spending for what they buy. You can see this most clearly in the price of oil. The US buys a large percentage of its oil from Canada. As the price of oil on the world market increases, the exchange rate of Canadian dollars to US dollars goes down - Canadian dollars become more valuable because the Canadian economy is growing stronger.

Obviously, there's far more to the intricacies of floating currency exchange rates, but this basic primer should help you understand some of the more complex writings on the subject.

The Top Currencies to Watch in the Forex Trading Game
What Drives Traders to Forex Markets