• retail forex brokers
• central banks
• commercial businesses
• banks

In countries using a centralized banking model, interest rates are determined by their respective central banks.

In order to determine the interest rate, a government’s economic observers create a policy that helps ensure stable prices and liquidity. This policy is routinely checked so that the supply of money within the economy is neither too large (causing prices to increase) nor too small (causing prices to decrease). In the U.S., interest rates are determined by the Federal Open Market Committee, which consists of the seven governors of the Federal Reserve Board and five Federal Reserve Bank presidents. The FOMC meets eight times a year to determine the near-term direction of monetary policy and interest rates.

For further background on the Federal Reserve’s functions, see our tutorial on The Federal Reserve.

Retail banks are typically the first financial institutions to expose money to the economy, and therefore they are the principal instruments used by the central bank to manipulate the money supply. Put simply, the central bank is able to regulate the supply of money to the end user (individuals and companies) by adjusting interest rates on the money it lends to or borrows from retail banks.

If the monetary policy makers wish to decrease the money supply, they will increase the interest rate, which makes it more attractive to deposit funds and reduce borrowing from the central bank. Conversely, if the central bank wishes to increase the money supply, they will decrease the interest rate, which makes it more attractive to borrow and spend money.

For further reading on interest rates, see “Interest Rates and Your Bond Investments,” “Forces Behind Interest Rates,” and “How Interest Rates Affect The Stock Market.”

The time value of money, or TVM, assumes a dollar in the present is worth more than a dollar in the future because of variables such as inflation and interest rates. Inflation is the general increase in prices, which means that the value of money depreciates over time as a result of that change in the general level of prices.

Changes in the price level are reflected in the interest rate. The interest rate is charged by financial institutions on loans (i.e., a mortgage or car loan) to individuals or businesses and TVM is taken into account in setting the rate.

TVM is also described as discounted cash flow (DCF). DCF is a technique used to determine the present value of a certain amount of money when received at a future date. The interest rate is used as the discounting factor, which can be found by using a present value (PV) table.

A PV table shows discount factors from time 0 (i.e., the current day) onward. The later money is received, the less value it holds, and $1 today is worth more than $1 received at a date in the future. At time 0, the discount factor is 1, and as time goes by, the discount factor decreases. A present value calculator is used to obtain the value of $1 or any other sum of money over different time periods.

For example, if an individual has $100 and leaves it in cash rather than investing it, the value of that $100 declines. However, if the money is deposited in a savings account, the bank pays interest, which depending on the rate could keep up with inflation. Therefore, it is best to deposit the money in a savings account or in an asset that appreciates in value over time. A PV calculator can be used to determine the amount of money required in relation to present versus future consumption.

To learn more about the basics of investing, see our Investing for Beginners crash course.

All currencies are traded in pairs. The first currency in the pair is called the base currency while the second is called the quote or “counterpart” currency. Usually the most dominant currency, in terms of the other currencies against which it trades, is quoted first. This is a matter of perspective because, from a local point of view, the local currency is the most dominant. One always wants to know just how much of the foreign currency one can get when exchanging the local currency. An American may want to know how many euros he can get for his dollar or, if he was traveling to Japan, how many yen he can get. (Interested in forex but don’t know where to start? Check out Top 7 Questions About Currency Trading Answered.)

However, based on international convention among banks, certain currencies have been assigned trading dominance. The euro represents some 17 countries that have joined the euro system and, therefore, has become the dominant base currency against all other global currencies, so it is quoted first. For example, the euro, represented as EUR, will be identified as EUR/USD, EUR/GBP, EUR/CHF, EUR/JPY, EUR/CAD, etc. All have the EUR acronym as the first currency in the sequence.

The British pound, originally the main currency of the world during the heights of the British Empire, is next in the hierarchy of currency name domination. The major currency pairs versus the GBP are identified as GBP/USD, GBP/CHF, GBP/JPY, GBP/CAD. Apart from the EUR/GBP, the GBP is usually the first currency quoted when it is involved in a currency pair. Because the U.S. dollar is the de facto world reserve currency since the end of the Second World War, and because commodity prices such as gold and oil are quoted in dollars, one could argue that the dollar is really the dominant currency of the world. In terms of convention, however, it ranks third in dominance and is quoted first against the Canadian dollar, Japanese yen and Swiss franc. In short, tradition and convention seem to play larger roles in the hierarchy of currency pairs than the relative economic strength of the economies that the currencies represent.(For further reading, see Using Currency Correlations To Your Advantage.)

Inflation is a term used by economists to define broad increases in prices. Inflation is the rate at which the price of goods and services in an economy increases. Inflation also can be defined as the rate at which purchasing power declines. For example, if inflation is at 5% and you currently spend $100 per week on groceries, the following year you would need to spend $105 for the same amount of food.

Economic policy makers like the Federal Reserve maintain constant vigilance for signs of inflation. Policy makers do not want an inflation psychology to settle into the minds of consumers. In other words, policy makers do not want consumers to assume that prices always will go. Such beliefs lead to things like employees asking employers for higher wages to cover the increased costs of living, which strains employers and, therefore, the general economy.

Stagflation is a term used by economists to define an economy that has inflation, a slow or stagnant economic growth rate and a relatively high unemployment rate. Economic policy makers across the globe try to avoid stagflation at all costs. With stagflation, a country’s citizens are affected by high rates of inflation and unemployment. High unemployment rates further contribute to the slowdown of a country’s economy, causing the economic growth rate to fluctuate no more than a single percentage point above or below a zero growth rate.

Stagflation was experienced globally by many countries during the 1970s when world oil prices rose sharply, leading to the birth of the Misery Index. The Misery Index, or the total of the inflation rate and the unemployment rate combined, functions as a rough gauge of how badly people feel during times of stagflation. The term was used often during the 1980 U.S. presidential race.

(To learn more about inflation and stagflation, see Stagflation, 1970s Style and Inflation: What Is Inflation?)

This question was answered by Tony D’Altorio.

Both LIBID and LIBOR are reference rates set by banks in the London interbank market. The London interbank market is a wholesale money market in London where banks exchange currencies either directly or through electronic trading platforms.

The acronym LIBID stands for London Interbank Bid Rate. It is the bid rate that banks are willing to pay for eurocurrency deposits and other banks’ unsecured funds in the London interbank market. Eurocurrency deposits refer to money in the form of bank deposits of a currency outside that currency’s issuing country. They may be of any currency in any country.

The most common currency deposited as eurocurrency is the U.S. dollar. For example, if U.S. dollars are deposited in any bank outside the U.S – Europe, the U.K., anywhere – then the deposit is referred to as a eurocurrency.

LIBOR (officially ICE LIBOR – see “Why Is LIBOR Sometimes Referred to As LIBOR ICE?”) stands for London InterBank Offered Rate. LIBOR is the interest rate at which banks can borrow money (unsecured funds) from other banks in the London interbank market for a specified period of time in a specified currency. The benchmark rate is calculated for seven maturities for five currencies: the Swiss franc, the euro, the pound sterling, the U.S. dollar and the Japanese yen. There are actually 35 rates that are released to the market every day.

LIBOR and LIBID are both calculated and published daily. However, unlike LIBID, which has no formal correspondent responsible for fixing it, LIBOR is set and published daily around 6:45 a.m. EST (11:45 a.m. in London) by the ICE Benchmark Administration (IBA).

Both these rates (especially LIBOR) are considered the foremost global reference rates for short-term interest rates of a variety of global financial instruments such as short-term interest futures contracts, forward rate agreements, interest rate swaps and currency options. LIBOR is also a key driver in the eurodollar market, and is the basis for retail products like mortgages and student loans. They are derived from a filtered average of the world’s most creditworthy banks’ interbank bid/ask rates for institutional loans with maturities that range between overnight and one year.

The London Interbank Mean Rate (LIMEAN) is the calculated average between LIBOR and LIBID and can be used to identify the spread between the two rates. LIMEAN is also used by institutions borrowing and lending money in the interbank market (rather than using LIBOR or LIBID), and is a reliable reference to the the mid-market rate rate of the interbank market.

To learn more, see “An Introduction to LIBOR.”

Point, tick and pip are terms used to describe price changes in the financial markets. While traders and analysts use all three terms in a similar manner, each is unique in the degree of change it signifies and how it is used in the markets. A point represents the smallest possible price change on the left side of a decimal point, while a tick represents the smallest possible price change on the right side of a decimal point. A pip, short for point in percentage, is similar to a tick in that it also represents the smallest change to the right of the decimal, but it is a crucial measurement tool in the forex market.

A point is the largest price change of the three measurements and only refers to changes on the left side of the decimal, while the other two include fractional changes on the right. The point is also the most generically used term among traders to describe price changes in their chosen markets. For example, an investor with shares in Company ABC stock might describe a price increase from $125 to $130 as a five point movement rather than a $5 movement.

Some indexes restate prices in a manner that allows investors to track price changes in points. For example, the investment grade index, or IG Index, tracks price movements to the fourth decimal. However, when quoting prices, it shifts the decimal four places to the left so movements can be stated in points. Therefore, a price of 1.23456 is stated as 12,345.6.

A tick denotes a market’s smallest possible price movement to the right of the decimal. Going back to the IG Index example, if this index elected not to shift the decimal place to use points, its price movements would be tracked in increments of 0.0001. A price change, then, from 1.2345 to 1.2346 would represent one tick. Ticks do not have to be measured in factors of 10. For example, a market might measure price movements in minimum increments of 0.25. For that market, a price change from 450.00 to 451.00 is four ticks, or one point.

A pip measures the price change in the currency market, with one pip equivalent to 0.0001. 

(To learn more about pips and their significance to forex markets, see “What Is a Pip?”)

The New Zealand currency is known as the New Zealand dollar. The currency was decimalized in 1967, and divided into 100 parts or cents. Before 1967, the currency was called the New Zealand pound. But since its decimalization, it has been called the New Zealand dollar. The currency, affectionately referred to as the Kiwi, trades under the symbol NZD or NZ$.

Since 1999, the New Zealand government has produced polymer or plastic versions of the New Zealand dollar, which has made the note more secure against counterfeiting. In addition, the new polymer composition has increased the longevity of the note. It is estimated that the polymer note lasts four times longer than regular linen or paper notes. Interestingly, the polymer note can go through a washing machine without suffering any material damage. Will other countries around the world follow suit and move their currencies from paper to polymer?

(For more on this topic, see What are the most common currency pairs traded in the forex market?)

In forex markets, currency trading is conducted most frequently among the U.S. dollar, the Japanese yen, the euro, the British pound and the Canadian dollar.

A currency pair such as EUR/USD, for example, represents the relationship between the euro and U.S. dollar. The first currency is the base currency and the second currency is the quote currency. So, to buy EUR/USD at 1.1200 on a trade for 100,000 currency units, you would need to pay US$112,000 (100,000 * 1.12) for 100,000 euros.

Four major currency pairs are the most traded and have the highest volume. These are known as the major pairs. They are the EUR/USD, USD/JPY, GBP/USD and the USD/CHF. These pairs all contain the U.S. dollar. In yen-denominated currency pairs, a pip is only two decimal places, or 0.01. This is 1/100th of a cent. Currencies are often traded in lots that are 1,000 units of the underlying currency.

A pip, an acronym for “price interest point”, is a tool of measurement related to the smallest price movement made by any exchange rate. Currencies are usually quoted to four decimal places, meaning that the smallest change in a currency pair would be in the last digit. This would make one pip equal to 1/100th of a percent, or one basis point. For example, if the currency price we quoted earlier changed from 1.1200 to 1.1205, this would be a change of five pips.

[Note: Pips are one of the most fundamental concepts to understand when trading currencies, but there are countless other concepts that forex traders need to know to be successful. Investopedia Academy’s Forex Trading course will teach you a proven strategy that you can leverage when trading all currencies. Check it out today!]

To get the value of one pip in a currency pair, an investor has to divide one pip in decimal form (i.e., 0.0001) by the current exchange rate, and then multiply that number by the notional amount of the trade.

Keeping with our earlier example for the EUR/USD currency pair, let’s say the value of one pip is 8.93 euros ((0.0001/1.1200) * 100,000). To convert the value of the pip to U.S. dollars, just multiply the value of the pip by the exchange rate, so the value in U.S. dollars is $10 (8.93 * 1.12).

The value of one pip is always different between currency pairs because of differences between the exchange rates of various currencies. A phenomenon does occur when the U.S. dollar is quoted as the quote currency. When this is the case, for a notional amount of 100,000 currency units, the value of the pip is always equal to US$10.

To learn more, see “Common Questions About Currency Trading,” “A Primer on the Forex Market” and “Forces Behind Exchange Rates.”