We’re all familiar with money, but how do we define it? Over time, money has taken on various forms. Among the items historically used as money were stones as well as metals including gold and silver in various forms and sizes. Nowadays, some even characterize cryptocurrencies as a form of money, though this is still a subject of debate with discussions around whether it is money or investment assets.
Investopedia offers a comprehensive definition of money: “Money is an economic unit that functions as a generally recognized medium of exchange for transactional purposes in an economy. Money provides the service of reducing transaction cost, namely the double coincidence of wants. Money originates in the form of a commodity, having a physical property to be adopted by market participants as a medium of exchange. Money can be market-determined, officially issued legal tender or fiat moneys, money substitutes and fiduciary media, and electronic cryptocurrencies.”
However, specific currencies are used in specific geographical regions. When you buy American shares, you use dollars. When you buy European equities, you use euros. Essentially, you need money to buy anything, even stocks. But the question is, ‘How do you buy money?’ The answer is simple – with money. You can buy euros with pounds, dollars with yen, yen with Australian dollars, and so on. You’ve probably engaged in an FX transaction when you visited a country with a different currency than your own. For example, if you live in the Eurozone, you mainly use euros as a means of payment. But if you plan a trip to the UK, you will have to convert some of your euros into pounds to make purchases in the UK. This transaction involves buying British pounds with a payment in Euros. Alternatively, from another perspective it looks like the sale of euros in exchange for pounds. Thus, money mainly serves as a means of payment, but currencies have an exchange value expressed in other currencies.
In an FX transaction when you sell one currency, you simultaneously buy another. The price of the currency you are selling varies uniquely with respect to each other currency, giving rise to FX rates. FX rates or currency pairs show the relationship between one currency and another currency at a particular moment. Each exchange rate comprises two distinct currencies: the base currency on the left and the variable currency on the right-hand side. The base currency is always expressed in one single unit of the currency, while the variable currency’s value fluctuates. It indicates how much of the variable currency you need to buy a single unit of the base currency.
For example, if EUR/USD trades at 1.0975 it means that one euro can be exchanged for 1.0975 US Dollars. If I plan a trip to the US and exchange 1,000 euros into US dollars, I will receive 1097.5 US Dollars.
In the following year, EUR/USD is at 1.1000. This means that 1000 euros can buy you 1100 US dollars (=1000*1.01000). With the same amount of euros, I would get more US Dollars indicating that the euro has appreciated relative to the US Dollar, or conversely the US Dollar has depreciated against the euro.
The exchange rate is determined by the main market forces of supply and demand. The objective is to buy the currency you expect will gain value in relation to the currency you are selling. Hence, we use expressions like: “The euro appreciated against the dollar” or “The yen depreciated against the pound.”
When we simply state “The Euro appreciated”, it is typically true and means that the Euro has appreciated against a wide range of other currencies, even though its worth remains lower compared to certain currencies. For instance, the Euro may appreciate against the US Dollar but depreciate against the JPY simultaneously due to various underlying factors.
