ABSTRACT
The foreign exchange (FX) market is enormous by any measure, with transactions amounting to approximately five trillion dollars every business day. The focus of this chapter is to demystify the FX market, as well as understand how supply and demand forces determine exchange rates and cause them to change. The currency being valued is always in the denominator of a nominal bilateral exchange rate. Exchange rates are similar to other economic measures, such as gross domestic product (GDP), in the sense that they can be stated in nominal and real terms. Most insightful economic analyses are conducted in terms of real exchange rates and not nominal ones. An effective exchange rate measures a currency's value relative to a basket of foreign currencies – usually those of major trading partners. The FX market is activated every time one currency is converted into another by households, businesses, governments, and/or central banks.
