6.2 - Exchange Rates
The Foreign Exchange Market
The FOREX market is a global electronic marketplace where currencies get traded for each other. The exchange rate is just the price of one currency in terms of another, and you’re always comparing exactly two currencies at a time.
Prices can be expressed either way: dollars in euros, or euros in dollars. And here’s the elegant part, one is simply the reciprocal of the other. If $1 = 1.5 euros, then one euro costs $1 ÷ 1.5, or about 67 cents.
With a flexible (floating) exchange rate, nobody sets this price. It’s set by supply and demand: people trading one currency for the other so they can buy goods, services, and financial assets from the other country. That market is the whole model in 6.3.
Relative Value and Conversion
If trading one unit of your currency gets you more than one unit of another, yours is more valuable. So in the $1 = 1.5 euro example, the dollar is the stronger currency.
One unit being worth more doesn’t tell you where a currency is headed, though. AP questions are about changes: is the currency gaining value (appreciating) or losing value (depreciating) compared to before?
Conversions just scale proportionally: at that rate, something priced at $30 would cost 45 euros (30 × 1.5), and something priced at 30 euros would cost $20 (30 ÷ 1.5).
Appreciation and Depreciation
Exchange rates shift constantly, the same basic logic as watching crypto prices move.
- Appreciation: a currency gains value relative to another. If the rate moves from $1 = 1.5 euros to $1 = 2 euros, the dollar has appreciated, since a dollar now buys more euros.
- Depreciation: a currency loses value relative to another, so one unit buys less of the other currency. If the dollar appreciates, the euro necessarily depreciates. Its value falls from 67 cents to 50 cents (1 ÷ 2), meaning a euro now buys fewer dollars than before.
Watch which way the rate is written. If the rate goes from $1.10 per euro to $1.25 per euro, it now takes more dollars to buy one euro, so the euro appreciated and the dollar depreciated. Flip it to check: a dollar went from about 0.91 euros (1 ÷ 1.10) to 0.80 euros (1 ÷ 1.25).
Bottom line: the exchange rate captures the relative value of two currencies, which are just reciprocals of one another. When one currency appreciates, the other automatically depreciates.