Know How Currency Works
Before investing in foreign markets, know how currency works
If you don’t have time to read through the whole article, you can check out our short version below:
- All currencies are valued against another currency, so they are always expressed as pairs.
- Various factors affect the value of currency, the changing value of currency is what provides opportunity to trade.
What is Currency?
Currency is generally defined as a ‘token’ used widely as a medium of exchange within an economy or a country. The Cambridge dictionary defines currency as ‘the money that is used in a particular country at a particular time’.
The idea of currency being a token stems from the fact that in general, the face value or monetary value of a currency exceeds its cost of production. So, the paper and ink of a $100 note is worth less than $100 in value.
We are all familiar with cash, which is held in different currencies, depending on which country you are in. Each currency is represented by a symbol, which you will need to know when looking up financial or trading websites.
The Value of Currency
All currencies are valued against another currency, so they are always expressed as pairs. So, USD/SGD stands for US Dollar valued against the Singapore Dollar.
When you come across statements like ‘the Yen tumbled’ or ‘the Aussie dollar strengthened’, these refer to the fall or rise of a currency against another. Typically, the default benchmark is the US Dollar. So, if we say the USD/JPY went from 100 to 102, this means the US Dollar gained in value against the Yen. Conversely, the Yen ‘fell’ against the US Dollar.
This changing value of currency is what provides an opportunity to trade for gains.
Economic factors that affect the value of currency
These factors affect the supply and demand for a currency. If certain economic events make a currency more attractive, demand increases against a limited supply and the currency can command a higher price.
On the other hand, when another currency becomes less attractive, owners of that currency may want to offload it as soon as possible. If there is a shortage of buyers, the price will fall.
Most developed economies’ currencies are valued this way, known as the ‘free float’, including the US Dollar and the Yen. Some currencies are ‘fixed’ or ‘pegged’ against another currency. An example of this is the Hong Kong Dollar, which is fixed in value against the US Dollar.
There are also currencies like the Singapore Dollar where the value is determined by a mix of market forces (demand and supply) and occasional central bank intervention to keep the currency value within a range. This is a ‘managed float’.
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