A:

Exchange rates float freely against one another, which means they are in constant fluctuation. Currency valuations are determined by the flows of currency in and out of a country. A high demand for a particular currency usually means that the value of that currency will increase.

Currency demand is driven by tourism, international trade, mergers and acquisitions, speculation, and the perception of safety in terms of geo-political risk. For example, if a company in Japan sells products to a company in the U.S. and the U.S.-based company has to convert dollars into Japanese yen to pay for the goods, the flow of dollars into yen would indicate demand for Japanese yen. If the total currency flow led to a net demand for Japanese yen, the currency would increase in value.

Currencies are traded around the clock – 24 hours per day. Even though trading hours vary – the morning in Tokyo occurs during U.S. nighttime – trade and banking continue around the world. Therefore, as banks around the world buy and sell currencies, the value of currencies remain in fluctuation. Interest rate adjustments in different countries have the greatest effect on the value of currencies, because investors typically gravitate toward safety with the highest yields. If an investor can earn 8.5% interest on deposits in the England, but can pay 1% interest for the use of money in Japan, then the investor would pay to borrow the Japanese yen in order to buy the British pound.

(For more on this topic, see "Get to Know the Major Central Banks" and "6 Factors That Influence Exchange Rates.")

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