Choosing a FOREX Broker

Just as in any other trading market, there are numerous brokers in the FOREX market to choose from. Here are a few things to keep in mind as you shop for one:Choose a broker that has lower spreads. The spread is the difference between the price which currency can be bought and the price at which it can be sold at any given point in time. FOREX brokers don't charge commissions, so this difference is how they make their money; therefore, the lower the better for you.Make sure that the broker is backed by a reliable financial institution. FOREX brokers are usually affiliated with large banks or lending institutions because of the vast amounts of leverage, or capital, that they need to provide. The broker should also be registered with the Futures Commission Merchants (FCM) and regulated by the Commodity Futures Trading Commission (CFTC). This information should be found on the broker’s website or that of the parent institution.The broker should provide market tools and research. FOREX brokers usually offer many different trading platforms for their clients. These platforms often include real-time charts, technical analysis tools, real-time news and other data. Brokers also usually provide technical commentaries, economic calendars and other research information.The broker should offer a wide range of leverage options. Leverage is the amount of money that a broker will lend you for trading. It’s expressed as a ratio of the total capital available to the actual capital invested; for example, a ratio of 100:1 means your broker is lending you $100 for every $1 of actual capital that you put up. Leverage is necessary in FOREX because the price deviations, which are the sources of profit, are so small, merely fractions of a cent. Lower leverage means lower risk of a margin call, but also a lower degree of profit. A variety of leverage options allows you to vary the amount of risk that you’re willing to take.Make sure the broker you choose offers the tools and services that are right for the amount of capital that you have. Many brokers offer two or more types of accounts. The smallest is known as a mini account; requires you to trade with a minimum of, perhaps, $250, and offers a high degree of leverage (which you’ll need in order to make money with such a small amount of initial capital). The standard account lets you trade at a variety of different leverages, but the minimum initial capital required is around $2,000. Premium accounts, which often require significant amounts of capital, allow you to use different amounts of leverage and often offer additional tools and services.Beware of Sniping and Hunting. This refers to brokers prematurely buying or selling near preset points in order to underhandedly increase profits. Of course, no broker is going to admit doing this. And since there are no blacklists or organizations that report such activity, the only way to determine which brokers do and which ones don't is to talk to other traders.Make sure the broker follows strict margin rules. When you are trading with borrowed money, your broker has a say in how much risk you take. This is because you are required to sign a margin agreement when you open an account. This agreement states that since you are trading with borrowed money, the brokerage has the right to interfere with your trades, at its discretion, in order to protect its interests. Depending on your position in the market, this could cost you a great deal of money. Again, talk to other traders or visit online discussion forums to find out who the honest brokers are.

FOREX Fundamentals

The use of Technical Analysis in the FOREX market is much the same as in other trading markets: price is believed to already reflect all news which would have had an effect on the currency’s value. But since countries don’t normally have balance sheets, how can Fundamental Analysis be conducted on a nation’s currency? Since this type of analysis involves looking at the intrinsic value of an investment, its application in the FOREX market will entail the study of the economic conditions that influence the valuation of the country’s money. Here are some of the major fundamental factors that play a role in the price movement of a currency.Economic indicators are reports that are released by the government or a private organization which detail the country's economic performance. These reports are the means by which a nation’s economic health is measured. (It must be kept in mind, however, that a great many factors will influence a country’s economic performance.) These reports are released at scheduled times, thereby providing a readable marker of whether a nation's economy has improved or declined. Some of the reports, such as unemployment numbers, are well-publicized. Others, like housing statistics, receive very little media coverage. However, each indicator serves a particular purpose, and can be very useful. Four major indicators are listed below:The Gross Domestic Product (GDP) is considered to be the broadest measure of a country's economy, and it represents the total market value of all goods and services produced by that country in a given year. Since the GDP figure itself is a lagging indicator, most investors focus on the two reports that are issued in the months before the final GDP is released: the advance report and the preliminary report. Significant revisions from one report to the next can often cause considerable market volatility.The Consumer Price Index (CPI) is a measure of the change in the prices of consumer goods across 200 different categories. This report, when compared to a nation's exports, can be used to determine whether a country is making or losing money on its products and services. The exports must be carefully monitored as well, however, because their prices often change relative to a currency's strength or weakness.A country’s Retail Sales report measures the total receipts of all retail stores. This report is particularly useful because it’s an indicator of broad consumer spending patterns, and is adjusted for seasonal variations. It can be used to predict the performance of more important lagging indicators. It’s also valuable in assessing the immediate direction of a country’s economy. Revisions to advance reports of retail sales can cause significant volatility.The Industrial Production report shows the change in the production of factories, mines and utilities within a nation. It also reports their 'capacity utilizations', which are the degrees to which the capacities of the factories are being utilized. Traders using this indicator are usually concerned with a nation’s utility production.There are many other important economic indicators, and still more private reports that can be extremely useful in evaluating FOREX fundamentals. It's important to not only look at the numbers, but to also take the time to know and understand what they mean and how they affect a nation's economy. When properly used, these indicators can be a valuable resource for the FOREX investor.

Getting Started in the FOREX Market

The FOREX market is the largest trading market in the world, and growing numbers of individuals are being drawn to it. But before you begin trading in it, be sure that the broker you choose meets certain criteria, and that you take the time learn the market and find a trading strategy that works for you. The best way to learn to trade FOREX is to open up a demo account and trade with it.Just as in equity markets, the two basic types of strategy in the FOREX market are Technical Analysis and Fundamental Analysis. But among FOREX traders the most common strategy used by far is Technical Analysis. Let’s compare the two.Fundamental Analysis in the FOREX market is often very complex, and it's usually only used to predict long-term trends; some investors, however, do trade short-term based strictly upon news releases. There are many different fundamental indicators of currency values, and they’re released at various times.But these reports are not the only fundamental factors should be watched. There are also a number of meetings that are held periodically, from which come quotes and commentaries, and they can have a very definite effect on markets as well. These meetings are often called to discuss interest rates, inflation, or other issues that affect currency valuations. Even changes in wording when talking about certain issues can cause spikes in market volatility.Reading these reports and examining the commentary can help FOREX traders using Fundamental Analysis to obtain a better understanding of long-term market trends. They can also help short-term traders to profit from extraordinary events. If you choose to use a fundamental strategy, be sure to keep an economic calendar close-by so that you’ll know when these reports are released.Technical analysts in the FOREX market evaluate price trends. The only real difference between Technical Analysis in FOREX and Technical Analysis in equity markets is the time frame: FOREX markets are open around the clock,24 hours a day. As a result, some forms of analysis which factor in time must be modified in order to work in the 24-hour FOREX market. Some of the more common forms of technical analysis used in the FOREX market include Elliot Waves, Fibonacci studies, and Pivot points. Many technical analysts combine these studies in order to make more accurate predictions. The most frequent combination is that of the Fibonacci studies with Elliott Waves.Most successful traders develop an investment strategy, and with repeated use, perfect it over time. Some people focus on one calculation or study; others may utilize a broad range of analysis tools to determine their investments. Most experts suggest using a combination of both Fundamental and Technical analysis. It is the individual investor, however, who must decide what fits and works best for him or her. This is usually accomplished through trial and error.Here are several suggestions to consider as you get started in the FOREX market: 1) Open a demo account and paper trade until you are comfortable and confident that you can make a consistent profit. In other words, isolate your learning mistakes to the time in which they won’t cost you. 2) Trade without emotion. Don't keep mental stop-loss points. Always set your stop-loss and take-profit points to execute automatically and don't change them unless it’s absolutely necessary. Make your decisions and stick with them. 3) Stay with the trend; if you go against it, make sure you have a very good reason. Movements in the FOREX market tend to be in trends more than anything else; you therefore have a higher chance of success in trading with the trend.

Introduction to FOREX Trading

Part 1: The BasicsThe term FOREX, which is an acronym for Foreign Exchange, refers to an international exchange market where currencies are bought and sold. The contemporary market began in the 1970’s with the introduction of floating currencies and free exchange rates, where supply and demand strictly determine the price of one currency against another.The FOREX market is unique for a number of reasons. It is, for instance, virtually free of any external controls, making it almost impossible for anyone to manipulate it. It is also the largest liquid financial market, with trading reaching nearly 2 trillion US dollars daily. With this volume of money moving frequently, it’s not difficult to understand why any single investor could significantly affect the price of any major currency. And because of its liquidity, positions in the market can be opened and closed extremely quickly.Some investors participate in the FOREX market for long-term hedge positions, while others utilize marginal trading to try to obtain large short-term gains. The combination of small but generally constant daily fluctuations in currency prices creates an attractive environment for a wide range of investors with differing investment strategies.There is no central FOREX exchange which handles all trading. Transactions take place all over the world via telecommunications. Trading is conducted twenty-four hours a day, from Monday 00:00 GMT to Friday at 10:00 pm GMT. (This equates to late Sunday afternoon through Friday afternoon in the U.S.) FOREX dealers operate literally around the globe, quoting the exchange rates of all major currencies. Investors can purchase currencies through these dealers. It’s a common practice for investors to speculate on currency prices by obtaining a credit line (which is available with as little as $500), thus vastly increasing their potential for gains, as well as losses. This is called marginal trading.Marginal trading simply means trading with borrowed capital. It has its appeal in the fact that FOREX investments can be made without a huge supply of capital. This allows traders to invest much more money, establishing bigger positions in the market, with much smaller amounts of actual money. This makes FOREX trading very easy to enter into for the new investor.Marginal trading in an exchange market is quantified in lots. The term lot designates approximately $100,000. This amount can potentially be obtained with as little as one-half of one percent down, or $500. Here’s an example: You believe that signals in the market indicate that the British Pound will go up against the US Dollar. You open 1 lot for buying the Pound with a 1 percent margin at the price of 1.49889, and then you wait for the exchange rate to climb. At some point in the future, your predictions prove accurate; the exchange rate climbs, and you decide to sell. You close the position at 1.5050, thus earning 61 pips, or about $405. So, on an initial capital investment of $1,000 you realized over 40% in profits. When you close a position, the deposit that you originally made is returned to you and a calculation of your profits or losses is performed. This profit or loss is then credited to or debited from your account.In Part 2 of this series, we’ll take a look at the two types of investment strategies used in FOREX trading: Technical Analysis and Fundamental Analysis.

Introduction to FOREX Trading - Part 2

Part 2: Technical Analysis and Fundamental AnalysisIn Part 1 of Introduction to FOREX Trading we looked at the origins, structure and proliferation of today’s FOREX market. In this article we’ll discuss the two investment strategies used by FOREX traders: Technical Analysis and Fundamental Analysis.Most small- to medium-sized investors in the FOREX markets use the form of investment strategy known as Technical Analysis. This technique stems from the assumption that all information about the market and a particular currency's future fluctuations can be found in the price chain. In other words, all of the factors which have an effect on the price of the currency have already been considered by the market and are therefore reflected in the price. The investor who uses Technical Analysis bases his investment decision on three essential suppositions: that the movement of the market inherently considers all factors; that the movement of prices is purposeful and directly tied to these events; and that history repeats itself. This investor considers the highest and lowest prices of a currency, its opening and closing prices, and its volume of transactions. He or she does not try to predict long-term trends, but simply looks at what has happened to that currency in the recent past, and supposes that the small short-term fluctuations will generally continue as they have before.An investor who utilizes Fundamental Analysis studies the current situations in the country of the currency, including such things as economy, political situation, and other related information. A country's economy can be quantifiably defined by measurements of its Central Bank's interest rate, its unemployment level, its tax policy and the rate of inflation. The prudent investor also knows, however, that less measurable conditions and occurrences can also impact a nation’s economy. He or she must furthermore keep in mind the expectations and anticipations of other market participants. Just as in any stock market, the value of a currency is also based in large part on the perceptions of and anticipations about that currency, and not solely on the reality of its condition.While the risk certainly is substantial, the ability to conduct marginal trading in the FOREX market allows for potentially enormous profits relative to the initial capital investments that are required. The sheer size of the FOREX prevents virtually all attempts by anyone to influence the market for their own personal gain. This has the effect of making the investor feel quite confident that when trading in foreign currency markets he or she has the same opportunity for profit as do other investors around the world. It must be stated, however, that, as with any investment, losses are a possibility. They can, and do, occur. And for the same principle that gives marginal trading its potential for huge gains, the possibility of huge losses is just as great.Although investing in the FOREX using short-term strategies requires definite assiduousness, experienced investors who utilize a technical analysis can generally feel confident that their ability to read the daily fluctuations of the currency market are sufficient enough to supply them with the knowledge necessary to make informed and prudent decisions.

Important Foreign Exchange Terms

ABA - A 9-digit code used by the American Bankers Association to define a specific bank. Each institution has its own unique number code.Ask price - The price at which a seller offers or it is willing to sell a currency to a buyer; also known as the offer price.Annualized - The extrapolation of the behavior of a certain measured factor (such as rate, volatility, etc.) from a given period of time to the expanse of one full year.Base currency - The currency in relation to which other currencies are quoted; the first currency listed in a currency pair; this is most often the currency of the home market in which the investor is trading.Basis point (or BPS) - A financial unit of measure that describes the percentage change in value of a security. One basis point is equal to one one-hundredth of one percent, i.e. 0.01%, or as a decimal 0.0001 (see Pip). For example, a change of 4.20 percent to 4.85 percent is a move of 65 basis points.Bid price - The price at which a buyer offers or is willing to pay to purchase a currency from a seller.Central bank - A particular country's governmental body that controls the nation's monetary policy and currency creation.Consumer Price Index (CPI) - A measure of the average price that a typical U.S. consumer pays for a standardized basket of goods and services as compared to the average price paid for that same basket of goods and services in an earlier base year.Cross rates - The foreign exchange rate between two currencies other than the U.S. dollar, which is the currency in which most exchanges are typically quoted. Thus, the cross rate would be expressed as the ratio of the dollar rates of the two currencies.Currency - the lawful denominated medium of exchange of a country. In the foreign exchange market, each country's currency is represented by a unique three-character ISO code. For example, United States dollars are identified USD, Euros are designated EUR, etc.Currency pair - The exchange rate relationship between two currencies whereby one currency is expressed in terms of the other. The first listed currency of the pair is called the base currency, and the second currency is known as the quote or counter currency. For example, USD/EUR is a common currency pair, and is pronounced "U.S. dollars per Euro."Day Trading - A highly specialized type of investing in which market positions are opened and closed with the same day (or within a few days at most). This type of trading is usually speculative in nature.Discount Rate - The interest rate that a private banking institution pays for loaned funds received from the U.S. Federal Reserve System.Exchange rate - The amount of a particular currency needed to buy a standardized amount of another currency.Exchange rate risk - The potential loss that an investor faces from a movement in bid/ask prices (i.e., exchange rates) that is adverse to the investor's open market position.Euro - The currency adopted as a result of the European Economic and Monetary Union (EMU); it replaced those of the following member countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain.Exposure - The risk that an investor accepts from any open investment position; the amount that can be lost; also known as market exposure.Federal Reserve System - The central bank of the United States, which has the responsibility of implementing the country's monetary policy and regulating the system's member banks.Fixed exchange rate - The official exchange rate set by the monetary authority of a country, typically its central bank.Floating exchange rates - Exchange rates that are determined by supply and demand.Foreign exchange - The exchange or trading of foreign currency (also known within the industry as Forex or FX); also, transactions that cause a change in the foreign currency position of a financial institution. Foreign currency is bought and sold on the foreign exchange market either for immediate (known as spot) or forward delivery.Foreign exchange market - An area (not necessarily confined to physical borders or boundaries) where buyers and sellers are in contact for the purpose of trading foreign currencies.Forward contract - A purchase contract that locks in the exchange rate for delivery on a specified future date. The buyer is typically required to put up a deposit (or margin) for the privilege of buying the future currency at today's rate of exchange.Hedging - A strategy used by traders and investors to protect an investment or portfolio against loss. With regard to currency transactions, a current sale or purchase would be offset by the investor contracting to buy or sell another financial instrument at a specified future date in order to the eliminate a profit or loss on the current sale or purchase by balancing it out. In this manner the risk due to price fluctuations is substantially negated.Interbank prices - Market rates that apply to currency prices for transactions of one million U.S. dollars or more; these prices differ from retail market rates.ISO - International Standards Organization, a global standard-setting body.Long position - A market position in which the investor has purchased a financial instrument (stock, commodity, currency, etc.) that he or she did not previously own, with the expectation of an increase in value (also known simply as long); opposite of short position.Margin - An investor-contributed cash percentage of the market value of securities held in a margin account; a cash deposit provided as collateral by the purchaser of a forward contract position.Market maker - An individual or financial institution that provides consistent buy and sell quotations for a particular security or securities. A market maker must carry an inventory of the securities quoted or have ready access to the quoted amounts.Offer price - See Ask price.Open position - Any market transaction (whether long or short) that has not yet either been settled by physical payment or effectively balanced out by an equal and opposite transaction for the same date.Overbought - A market circumstance in which the movement of a currency pair price has risen at least 150 percent more violently than normal, overreacting to net buying activity. As a result, a price correction will generally be expected to soon take place; in other words, investors will expect the price of the currency pair to presently fall.Oversold - A market circumstance in which the movement of a currency pair price has fallen at least 150 percent more violently than normal, overreacting to net selling activity. As a result, a price correction will generally be expected to soon take place; in other words, investors will expect the price of the currency pair to presently rise.Point (or Pip) - The smallest incremental move that an exchange rate can make. Because most currency pairs are priced to four decimal places, the smallest incremental move possible would be a change of 0.0001, which is equivalent to one Basis point. For example, a currency that has moved from a price of 1.4580 to 1.4583 has risen three points (or pips).Portfolio - The total selection of securities held by an investor or financial institution. A primary function of the portfolio is to manage and minimize investment risk.Price movement - The change in price of a particular currency over a given period of time.Retail prices - Market currency prices that include commissions and other charges which exchange agencies or banking institutions levy in order to convert currencies for non-corporate (i.e., private) clients.Risk - The chance that an investor's return-on-investment (ROI) will be different from that expected, including the potential for loss of part or all of his or her investment funds.Settlement - The final stage or culmination of a transaction, identified by the physical exchange of one currency for another.Short position - A market position in which the investor has sold a financial instrument (stock, commodity, currency, etc.) that he or she did not previously own, with the expectation of a decrease in value (also known simply as short); opposite of long position.Spot - A transaction that will reach settlement within two days.Spot price - The current market price of a spot transaction.Spot rate - A spot transaction's current rate.Spread - The difference between a currency's bid and ask prices.Stop-buy - A buy order that is executed when an investor-specified price (which is above the current ask price) is reached; used to enter the market when prices are expected to continue to rise.Stop-loss (or Stop order) - An order that is executed when an investor-specified price is reached to close the market position by either buying or selling (depending upon whether the position is long or short) to limit the investor's loss from a damaging price move.Trend - The direction of the market; generally identified as either a major, intermediate, or short-term trend. A trend's direction may be upward, downward, or sideways.Volatility - A measure by which prices are expected to fluctuate or have fluctuated during a given period of time.

Operating in the FOREX Market

Although the purpose is the same, trading and operations of the FOREX market are slightly different from those of other equity markets. There are a few things which the new FOREX investor must become familiar with. For instance, concerning the specifics of buying and selling on FOREX, it’s important to note that currencies are always priced in pairs. All trades, therefore, will result in the simultaneous purchase of one currency and the sale of another. When operating in the FOREX market, you would execute a trade only at a time when you expect the currency which you are buying to increase in value in relation to the one that you are selling. If the currency that you bought does increase in value, you must then sell the other currency back in order to lock-in your profit. Therefore, an open trade, or open position, is a trade in which the investor has bought or sold a particular currency pair but has not yet sold or bought back the equivalent amount in order to close the position.Currency traders must also become familiar with the way in which currencies are quoted. The first currency in the pair is considered the base currency; the second one is the counter- or quote currency. The majority of the time, the U.S. dollar is considered the base currency, and quotes are expressed in units of “US$1 per counter currency” (for example, USD/JPY or USD/CAD). The only exceptions to this are quotes given for the euro, the pound sterling and the Australian dollar; these three are quoted as “dollars per foreign currency”.FOREX quotes always include a bid- and an ask price. The bid is the price at which a market maker (or broker/dealer) is willing to buy the base currency in exchange for the counter currency. The ask price is the price at which the market maker is willing to sell the base currency in exchange for the counter currency. The difference between the bid and the ask prices is called the spread.The cost of establishing a position in the market is determined by the spread, and prices are always quoted using five figures (136.70, for example). The final digit of the price is referred to as a point, or pip, which is the smallest price change that a given exchange rate can make. For instance, if USD/CAD was quoted with a bid price of 136.70 and an ask price of 136.75, that five-pip spread is the cost of trading into this position. The trader, therefore, must recover the five-pip cost from his or her profits, necessitating a favorable move in the position in order to simply break even.Margin on the FOREX is not a down payment on a future purchase of equity as in other markets, but a deposit made to the trader's account that will cover against any losses in the future. A typical currency trading system will allow for a very high degree of leverage in its margin requirements, up to 100:1 or more. The system will automatically calculate the funds necessary for current positions and will check for margin availability before executing any trade.As you can see, trading in FOREX requires a slightly different mindset than that which is needed for equity markets. Yet, for its extreme liquidity, the multitude of opportunities for large profits and high levels of available leverage, the currency markets are quickly growing in popularity among investors. Traders should always be aware, though, that with such potential for gain there is also significant risk for loss; they should therefore quickly become familiar with various methods of risk management.

The Effects of U.S. Dollar Fluctuations

Movements in the foreign exchange value of the United States dollar have an effect on the U.S. economy, interest rates, domestic and international trade, investments, and the monetary policies of not only America but other nations around the world. The effects of a rising greenback relative to other currencies are varied and substantial. Let's examine some of the consequences that a stronger dollar would generate on the global economic stage (a falling dollar would, of course, produce opposite effects). For example:Foreign individuals holding U.S. dollars would receive more foreign currency per dollar when exchanging those dollars for their home currency. American travelers abroad would also benefit from a stronger dollar, receiving a greater amount of local currency for each dollar they trade.Foreign-based importers who sell goods or services to the United States are paid in dollars and would therefore obtain more of their home currency in exchange. As a result, they can afford to charge less in dollars for their goods or services, and can be more competitive relative to U.S. providers of similar items. Consequently, imports would rise in the U.S. balance of payments accounts. Demand for comparable domestic goods and services would drop, and price competition from imports would further reduce the ability of U.S. companies to increase prices, which in turn would put downward pressures on inflation. The slowing of the economy and downward price influences would help to depress U.S. interest rates.U.S. exporters selling their goods and services overseas are paid in foreign currencies and therefore receive fewer dollars when those currencies are changed into dollars. For this reason, U.S. exports must be priced higher or profit margins and profits will be lowered. Exports from the United States are thereby discouraged, and exports in the U.S. balance of payments accounts drop, causing the economy to slow. Again, downward pressure on U.S. interest rates results due to this weakening in demand.Foreigners holding investments in the United States receive more income when they convert interest, dividends, and rent from dollars into their home currency. The value of those U.S. investments also appreciates when translated into their native tender. Foreign investment in the United States becomes more attractive, especially if the dollar is expected to continue to appreciate. Foreigners' willingness to invest in the U.S. continues as long as they feel little concern for the safety of their investments and have no fear of default. Because of the supply of funds flowing to America from abroad, U.S. interest rates are forced downward due to lower monetary demands.Foreign investors who want to buy U.S. investments in a strong dollar market must pay more of their own currency to acquire dollars for the purchase. Therefore, investment in the United States is discouraged unless the investors believe that the value of the dollar will continue to rise. However, if investing from foreigners becomes sufficiently dissuaded, funds for domestic uses would have to come from domestic sources, thus placing upward pressures on U.S. interest rates.Oil prices are denominated in U.S. dollars; therefore, dollar fluctuations have no effect on the cost of U.S. oil imports. However, other countries would need more of their currencies to obtain the necessary dollars to purchase oil, thereby diverting more resources to the procurement of oil and depressing their economies. Conversely, a stronger dollar would help oil-producing nations by allowing them to buy more foreign goods with the more valuable dollars they receive.

Why Foreign Exchange Rates Change

While almost every economic event has at least some indirect influence on the relative value of different currencies, there are generally six major factors that cause the value of currencies to rise or fall relative to one another. Let's take a look at each one:Purchasing power parity. This theory – first presented in the sixteenth century – is possibly the most important factor that causes the relative values of two currencies to change with regard to each other over time. In an oversimplified form, "PPP" suggests that the same goods should cost the same amount of money in different countries, allowing for the then-current rate of exchange. If this were not true, it would create the possibility of a virtually riskless arbitrage (which is the simultaneous or near-simultaneous purchase and resale of the same securities, commodities, or foreign exchange in different markets in order to profit from unequal pricing). The arbitrage would cause the value of the currency of the country in which the goods were cheaper to increase relative to the currency of the country in which the goods were more expensive.To illustrate the concept, let's assume that – at a time when the exchange rate of Japanese yen to U.S. dollars is 100:1 – an ounce of silver can be bought or sold for 550 yen in Japan and for $5 in the United States. Under these circumstances an investor could conceivably buy silver in the United States for $5 per ounce and immediately turn around and sell it in Japan for 550 yen per ounce. The investor could then straight away buy dollars with the yen received from that sale at the then-current exchange rate of 100:1 for a net of $5.50 – or a $0.50-per-ounce profit. Provided the transactions occurred nearly simultaneously, the tactic would be almost completely of risk. The investor could then repeat these dealings over and over again.As a result, several things would happen. Because the investor buys the silver in the United States, the price of silver in the U.S. would begin to rise. Further, because the silver is sold in Japan, the price of silver there would decline start to fall. And due to the exchange of yen for dollars, the value of the yen would decline relative to the dollar. The prices of silver in Japan and the U.S., as well as the yen-to-dollar exchange rate, would continue to change until the transactions no longer generate a risk-free profit. Keep in mind, however, that this example is an oversimplification, because transaction charges, import duties, shipping costs and the like aren't factored into the calculation. Although the price differential would strengthen the yen against the dollar, the price differential of other products might result in the weakening of the yen. Whether PPP works to actually raise or lower the value of the yen against the dollar, therefore, ultimately depends upon the net price differential of all the goods and services that are traded between the United States and Japan, always allowing for the then-current rate of exchange.Relative interest rates. Another factor that affects exchange rates is the size of the differential between the real interest rates available to investors in the respective countries. The real interest rate is simply the nominal interest rate available to an investor in a high quality short-term investment subtracted by the country's inflation rate.Using our same two example countries again, let's this time assume that the U.S. has a hypothetical nominal interest rate of 8% and an inflation rate of 3%. Its real interest rate would therefore be calculated at 5% (8% - 3%). Assume Japan's nominal interest rate is 3% while its inflation rate is at 2%; this would give Japan a real interest rate of 1%. Because the real investment return available in the United States is five times larger than the investment return available in Japan, some percentage of Japanese investors can be expected to want to invest in the U.S. In order to do that, however, they'll first have to sell their yen to buy dollars. This exchanging of yen for dollars will cause the dollar to rise against the yen. Additionally, U.S. investors will have less incentive to invest in Japan and, consequently, will reduce their buying of yen with dollars.Trade imbalances. The size of any trade deficit between two countries will also affect those countries' currency exchange rates. This is because they result in an imbalance of currency reserves among the trading partners. Once more using Japan and the U.S., consider the following example:Throughout the 1980s and 90s, Japan consistently ran fairly substantial trade surpluses with the United States. Consequently, Japanese companies accumulated a large amount of dollars, while U.S. companies amassed significantly fewer yen. Eventually, however, the Japanese companies must convert the dollars that they accumulated into yen and the United States companies must convert their yen into dollars. Given the mismatch in the amount of currencies to be exchanged between the two countries, the law of supply and demand would tend to distort the exchange rate. The American companies found themselves in a strong position to demand a greater number of dollars in exchange for their limited amount of yen. Thus, the U.S. trade deficit with Japan caused the yen to strengthen against the dollar.Political stability. During the gold standard of the past, currencies were backed by, and interchangeable with, precious metals. Anyone who held a country's currency could present the currency to the country's central bank (or any major bank in the country) and receive a fixed amount of gold or silver. Over the last few decades, however, the tremendous increase in the size of the economy created a need for money that far outdistanced the ability of the mining industry to produce gold. Therefore, the United States, like all other countries, had little choice other than to discontinue the gold standard. This meant that holders of paper dollars could no longer exchange them for gold.Today, instead of precious metals, "confidence" backs the world's currencies. The only reason that anyone is willing to accept paper money in exchange for their goods or services is because they're confident that they'll be able, in turn, to pass the paper money on to someone else in exchange for the things that they want or need. Most countries require their citizens to accept their paper money as payment; this is known as legal tender. As long as the citizenry's confidence remains intact, the system works. However, if a country's government becomes unstable due to political gridlock, votes of no confidence, revolution or civil war, confidence can quickly be lost. People become less willing to accept paper currency in exchange for their goods and services, primarily because they're unsure whether they'll be able to pass the paper along to the next person.Government intervention. The relative value of a country's currency is of great importance to its government. The value of a country's currency affects the wealth of its citizens, the competitiveness of domestically produced goods, the relative cost of the country's labor, and the country's ability to compete. As a result, governments often try to influence the relative value of their country's currencies in a number of different ways, including altering their monetary and fiscal policies, and by directly intervening in the currency markets.The term monetary policy refers to a country's decisions regarding how much money to print. In the United States, this decision falls primarily on the Federal Reserve, commonly called the Fed. The law of supply and demand applies no less to money; therefore, if a country prints more money, the value of its currency declines – a process known as monetary inflation. If a country prints less money, or more specifically, if the money supply grows at a rate that's lower than the growth rate of the economy, the result is deflation. As the value of a country's currency declines, its people become less wealthy but its businesses become more competitive globally. More competitive businesses translate into more jobs. The Fed's policy makers constantly try to balance the preservation of wealth of the country's citizens with the competitive needs of domestic companies.Fiscal policy refers to a country's decision regarding whether to run a budget deficit or a surplus. In the U.S., Congress determines the nation's fiscal policy. A budget deficit will cause the value of the dollar to decline because such deficits often lead to monetary inflation. A budget surplus will generally cause the dollar's value to strengthen.Because short-term variations can have a negative impact on business and global trade, most countries will attempt to reduce any short-term fluctuations in the value of their currencies by directly intervening in the currency market. If the country's currency is being sold, they will buy it; if the currency is being bought and becomes too strong, they'll sell it.Speculators. Perhaps the most powerful factor that can influence exchange rates over short time frames is the role that speculators play. Speculators typically have tremendous amounts of capital that they can use to either buy or sell any currency. Consequently, their actions can cause the value of such currency to fluctuate, sometimes quite significantly.