The value of a country's currency is dependent on many factors that will cause it to fluctuate, relative to other world currencies. Higher interest rates can attract foreign investment, while lower rates cause investors to look elsewhere for better returns. The economic health of a country, both current and predicted, also plays a key role. Recent events, such as the 2008 financial meltdown in the U.S. and the economic crisis in Greece, have sent shockwaves throughout the world and affected the valuations of the major world currencies.
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The trading of currencies takes place on the foreign exchange market. Without a central headquarters, it consists of an electronic network with major trading centers located in places like the U.S., U.K. and Japan. This facilitates international investment and trade through real-time conversion of one country's currency into that of another country. Most exporters expect to be paid in their own currency, but may accept U.S. dollars, which are widely accepted throughout the world. (Examining open interest on currency futures can help you confirm the strength of a trend in forex market sentiment. Find out more, in Gauging Forex Market Sentiment With Open Interest.)

Currency Speculation
Like stocks and other investments, there is speculation in currency trading, both long and short. In a process known as "carry trade," low-yield currencies are borrowed and then invested in high-yield currencies. This weakens the borrowed currency, since it is sold and converted into other currencies. The risk of this trade is that the value of the borrowed currency may rise at the time you need to pay it back. (Trade 10 of the most popular currency pairs risk free on our NEW forex simulator, FXtrader.)

Prior to the implosion of the credit bubble in the U.S., low interest rates in Japan prompted significant carry trade using the yen as the borrowed currency. This contributed to the U.S. housing bubble as the yen was used to fund high levels of subprime lending.

Market Psychology
Currencies rise and fall as a function of their perceived value against all other currencies. Changes in market psychology are driven by a multitude of factors within a country, including: prevailing economic conditions, standing in international trade, balance of trade status, financial and economic policies, political uncertainties, commodity prices, debt levels and natural or man-caused disasters.

Floating currencies are publicly traded and are subject to the same ups and downs of the traditional equity markets. Volatility in the forex market has increased over the past couple of years, as events have unfolded in the U.S. and Europe. Hedging is used by some investors to minimize the risks associated with exchange volatility. Risk is offset by simultaneously establishing positions in more than one currency. For example, if a company is doing business in the U.S. and Japan, it might have positions in both dollars and yen to diminish the impact of currency fluctuations between the two countries.

Currency Performance
The five most heavily traded currencies in the world are typically the U.S. dollar, British pound, euro, Japanese yen, and Swiss franc. Two statistical evaluations are presented below to track performance of these five currencies and five other major currencies. The left column shows the change in value against the Swiss franc, which is considered a relatively neutral measure of comparative value. The right column shows the change in value of the same currencies against the U.S. dollar. The time span for both calculations is January 19, 2010 through May 26, 2010.

Currency Value Change Versus

Swiss Franc U.S. Dollar

Euro (EUR)
-4% -16%
British Pound (GBP) -2% -13%
Swiss Franc (CHF) - -12%
Australian Dollar (AUD) 1% -10%
Russian Rouble (RUB) 6% -5%
Indian Rupee (INR) 8% -3%
Canadian Dollar (CAD) 8% -3%
Chinese Yuan (CNY) 11% 0%
American Dollar (USD) 11% -
Japanese Yen (JPY) 11% 0%

The five currencies hit hardest this year are the euro, pound, Swiss franc, Australian dollar and rouble. The data shows that the strongest currencies during this period were the U.S. dollar, yuan and yen. Outside of the European Union, the United States, China and Japan also have the three largest economies as measured by GDP.

The euro has been battered by the financial crisis in Greece and the uncertainty surrounding the other countries tagged as "PIIGS." This group, comprised of Portugal, Italy, Ireland, Greece and Spain, are all facing economic and debt problems that have driven investors away from the euro. The weak euro may actually help Greece because its exports will appear more attractive to countries outside the European Union.

The Bottom Line
While the U.S. certainly has its own debt problems, its currency and government-issued securities are considered relatively safe havens. Along with China and Japan, the American economy is still viewed as one of the strongest places to invest capital. How the U.S. deals with its growing debt will undoubtedly play a large role in the future value of its currency.

Catch up on the latest financial news, in Water Cooler Finance: Crying Over Spilled Oil, And Buffett Goes To Court.

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