How is exchange rate decided?

In super-simple mode, it%26#039;s determined by supply and demand. There are currency exchange markets all over the world where financial experts trade one currency for another based on the supplies that the sellers have on hand, and the demand for goods that the buyers want to buy in that currency (usually equities / debt).

For example, here are the bid / ask prices for US dollars against a variety of other currencies:

http://www.fxstreet.com/nou/dolargran.as...

Forex trading is very different from securities trading, though, because everything has to be in relation to everything else. If Currency A = Currency B and Currency B = Currency C, then Currency A must = Currency C at all times. Seems simple in theory but any change in one currency relationship has to be reflected (almost) instantaneously in every other relationship on the board, or else you%26#039;d easily be able to get into a cycle of trading A for B, B for C, and then C for A over and over and making a profit on every cycle.

How is exchange rate decided?

Well, there is no such thing as ONE fx-rate. Actually what you see listed are prices two parties have agreed to (in the past) based on their respective relative valuation of the currencies.

If the question is how those values are determined, the aswer is porbably nobody really knows. But there are a few basic models that can explain exchange rates and in general they are not too bad at it:

1. (Real) interst rate parity

2. Forward Parity

3. Purchasing Power Parity (-%26gt;Big Mac Index)

All those models rely on the assumption of market efficiency (-%26gt; Efficient Market Hypothesis), specifically they assume that no risk free (excess) profits can be earned in the financial markets (-%26gt;No Arbitrage / %26quot;There is no free lunch in finance).

All those models can easily be looked up in wikipedia.

Cheers,

Alex