What are currency rates and why do they exist
When an American owned Toyota dealership in the United States buys cars from the manufacturer – Toyota, Japan the price is in Japanese Yen. The American dealership checks the current exchange rate of U.S. dollars for Japanese Yen and figures out how many U.S. dollars each car will cost. If the dealer chooses to do so he can call a Bank and enter into a foreign exchange contract. The Bank will give him the Japanese Yen he needs to buy the cars and in exchange the dealer will give the Bank the U.S. dollars. The number of Yen the dealer receives for those U.S. dollars is the exchange rate. For example, if the dealer received 112,000,000 yen for $1,000,000; the exchange rate would be 112.00 (112,000,000 Yen/ $1,000,000).
To do this identical transaction on the FXCM platform, the dealer would wait until the quoted price was 112 00-04. The dealer would sell 100 lots at 112.00; thereby selling U.S. dollars and buying Japanese Yen. We refer to this as selling USDJPY.
Without a reference exchange rate that the dealer could rely on and be able to transact at, he could not do business with Toyota, Japan. Foreign exchange rates therefore exist to facilitate trade between different countries that use different monies.
History and evolution of foreign exchange rates
From 1944 to 1971 the world operated under a system of fixed exchange rates. The U.S. dollar was convertible into gold at a set rate and all the countries fixed their currencies to the U.S. dollar at a set rate. There was no need for a foreign exchange market.
On August 15, 1971 all that changed. President Nixon announced that the U.S. dollar could no longer be cashed in for gold. In 1973 the U.S. formally announced the permanent floating of the U.S. dollar thereby officially ending the system of fixed exchange rates.
Exchanges rates between different countries began to fluctuate widely; creating the need for a foreign exchange market where exporters and importers could lock in rates; clearly a prerequisite for doing business. Simply put, an American Hondo dealer is quoted a price per car in Japanese Yen from Honda, Japan. If the dealer could call a Bank and get a current dealable price for USDJPY, then the dealer would know for sure how much those cars were costing him and whether or not he could sell them profitably in his dealership.
And this is exactly what began happening. U.S. importers bought their Yen when they signed a contract to buy Hondos; then they left the Yen in the Bank earning interest until contract payment date. It didn’t take long for the Banks to figure out they could provide value added service by quoting the importer a price for the contract date. The Bank did this by simply starting with the current rate and adjusting the current rate to account for the net interest earned or paid from trade date to contract date. This became known as the forward rate.