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Understanding currency rates is as simple as going to a carnival

Jun 09, 2016 11:47AM ● Published by Neighbors Magazines

by Steve Ciaccio, MBA, CPA, CFP

At some carnivals, you do not pay for each ride or meal with cash. First, you buy tickets at a booth. Then, you give the tickets to the various vendors for rides, meals, souvenirs, etc. If the price of a ticket is one dollar and a meal costs three tickets, then the price of the meal is three dollars. What would happen if the next day, the price of tickets dropped to seventy five cents? If the price of a meal is still three tickets, then the cost of the meal is now $2.25 in terms of U.S. dollars. The opposite would happen if the price of tickets went up. In each scenario, the cost of lunch is three carnival tickets, but the price in dollars fluctuates.

It is much the same when visiting foreign countries or buying products from them. Think of the foreign currency as tickets at the carnival. The vendor charges a price of a product in terms of his or her local currency. For example, when you buy something in Japan, you will have to use U.S. dollars to buy a number of Japanese Yen, then use the Yen to buy the product. The number of U.S. dollars and cents that you must pay in order to purchase a unit of another country’s currency is called the exchange rate. The exchange rates for many foreign currencies fluctuates throughout the day, and also throughout the night. When the exchange rates fluctuate, the cost of the product can change in terms of U.S. dollars even though the local vendor keeps the price steady in the local currency. It works very similarly to the carnival tickets. Exchange rates have a similar effect when investing in foreign investments.

What would cause exchange rates to fluctuate? That is the subject of a very large and complex set of variables. However, it might be easier to think of it in terms of an auction. When there are a lot of bidders bidding on one item at an auction, the price tends to rise. If there are a lot of sellers selling the same item at an auction to only a few buyers, the price of the item will likely not go very high. As more sellers enter the market, the price might drop from its current level. Although some countries exert a level of control over their currency’s exchange rate, supply and demand drives the prices of many currencies.

Investing in foreign currencies and in foreign investments can be very risky. This article is not a recommendation to do so. However, it is intended to make the effects of foreign currency exchange rates understandable so you can see how it affects our daily lives.

Food for thought…understanding financial management is like putting together a very large puzzle. The more pieces that you fit into place, the easier it is to figure out the rest of the picture.

All the best to you!

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