Identification

• The foreign exchange rate is the amount of money you need to spend in one currency to purchase another. This process is frequently called "currency conversion."
  
  

Function

• The foreign exchange rate is set in most cases by activity on the foreign exchange market (FOREX or "currency market"). This market can only exist because of the prevalence of fiat currency. Unlike money that is made out of or backed by precious metals, fiat currency only has value because the issuing government says that it does. However, there are some examples where the exchange rate is set by government order, and the currency is not allowed to "float" on the open market. China, for example, has a "managed" floating exchange rate, where supply and demand in FOREX influence, but do not determine the currency's exchange rate.
  
  

Features

• In actual practice, a currency's value is never derived solely on the basis of what a government says it should be. Instead, it is a mixture of what a government says it should be, what that government's fiscal policies are, the health of the country's economy and what people think the value of the currency should be. The latter gives rise to the practice of trading currency as if it were a commodity, and thus the foreign exchange or currency market.
  
  So, for example, if a government is running a high, systemic deficit; has a weak economy; and is suffering a string of financial scandals, it will fall in value towards what the actors on the market perceive its real value to be. State banks, private banks, and corporations will start selling that currency for more valuable or stable currencies, and speculators will begin betting against it. The result is a dumping of the undesired currency, and a scramble to buy up other forms of money. This is exactly what happened when the US dollar went into a record, downward spiral against the Euro, Pound Sterling, and Yen in 2007 and 2008.
  
  

Benefits

• The main benefit of the fiat currency system and its floating exchange rate is that market adjustments in value are usually more timely and less shocking than those dictated by a government. Under the previous gold standard, government treasuries were often slow to adjust their currency conversion rates, and those adjustments were either too small or large and sudden by the time they were made. While FOREX is prone to distortion due to speculative pressure, most of the time it represents something close to the real value of a foreign currency.
  
  

Considerations

• The most heavily traded of the world's currencies are the U.S. dollar, the Euro, the British pound sterling, the Japanese yen and the Swiss franc.