Money’s Dual Nature and Exchange Rates

We all know money, but how we actually define it. In the passing of time money took different forms. It’s characteristic that among a number of items used were also stones as well as metals including but not only, gold and silver in various forms and sizes, while today some even characterize cryptocurrencies as forms of money, albeit the last is still being disputed as t is money or investment titles.

It’s characteristic that Investopedia is defining money as: “Money is an economic unit that functions as a generally recognized medium of exchange for transactional purposes in an economy. Money provides the service of reducing transaction cost, namely the double coincidence of wants. Money originates in the form of a commodity, having a physical property to be adopted by market participants as a medium of exchange. Money can be market-determined, officially issued legal tender or fiat moneys, money substitutes and fiduciary media, and electronic cryptocurrencies.”

Yet as we saw in the previous discussion specific currencies are being used in specific geographical areas. When you buy American shares, you use dollars. When you buy European equities, you use euros. You need money to buy anything, even stocks. But the question is, ‘How do you buy money?’

Again, with money of course. You can buy euros with pounds, dollars with yens, yens with Australian dollars. You’ve probably done an FX transaction yourself when you’ve been to a country that uses a different currency than the one used in your own country.

Say for example if you live in the Eurozone, euros are used as a means of payment. If you want to take a trip to the UK, you will have to convert some of your Euros into pounds in order to be able to buy anything in the UK.

But effectively what the actual transaction in this case is the purchase of British pounds with a payment in Euros. However from a different perspective it would also resemble the selling of Euros with a receipt in pounds. Hence money is primarily used as a means of payment, but at the same time currencies have an exchange value that is expressed in a different currency.

So whenever an FX transaction occurs at the same time the seller of a currency is also the buyer of another. you’re selling another, and the price of the currency you are selling is unique for each and every other currency.

And that’s why we have FX rates. FX rates or currency pairs depict the relationship of one currency against a certain other currency at a certain point of time. For each exchange rate, there are a set of two unique currencies. On the left-hand side, there is the base currency and on the right-hand side is the variable currency. The base currency is always denominated in one single unit of the currency mentioned while the variable currency is the one that fluctuates in value. It’s how much of the variable currency you need to buy a single unit of the base currency.

When we say for example that EUR/USD trades at 1.0975 that means that one Euro buys you 1.0975 US Dollars.

For example if I want to take a trip to the US I would have to exchange my Euros into US dollars. If I exchange 1000 Euros into Dollars, given that the exchange rate is currently at 1.0975 that would give me 1097.5 US Dollars.

Let’s say that the following year EUR/USD is at 1.1000. Now 1000 Euros buys you 1100 USD (=1000*1.01000). With the same amount of euros, I get more US Dollars. This means the euro appreciated relative to the US Dollar, or the US Dollar depreciated against the euro.

The rate is as such determined by the main market forces of supply and demand.

The aim here is to buy the currency you expect to appreciate relative to the currency you sell. That’s why we use expressions:
“The euro appreciated against the dollar”
“The yen depreciated against the pound”

Just saying “The Euro appreciated”, in general it is still valid and means that the Euro appreciated against a wide number of other currencies yet still has much less value. The Euro may behave differently depending on the counterpart currency, say for example it may appreciate against the US Dollar but for other reasons depreciate against the JPY, at the same time.