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Foreign currency exchange rates are what it costs to exchange one countrys currency for another countrys currency. For example, if you go to England on vacation, you will have to pay for your hotel, meals, admissions fees, souvenirs and other expenses in British pounds. Since your money is all in US dollars, you will have to use (sell) some of your dollars to buy British pounds.

Assume you go to your bank before you leave and buy $1,000 worth of British pounds. If you get 565.83 British pounds (?565.83) for your $1,000, each dollar is worth .56583 British pounds. This is the exchange rate for converting dollars to pounds.

If ?565.83 is not enough cash for your trip, you will have to exchange more US dollars for pounds while in England. Assume you buy another $1,000 worth of British pounds from a bank in England and get only ?557.02 for your $1,000. The exchange rate for converting dollars to pounds has dropped from .56583 to .55702. This means that US dollars are worth less compared to the British pound than they were before you left on vacation.

As you can see from the example, currency exchange rates fluctuate. As the value of one currency rises or falls relative to another, traders decide to buy or sell currencies to make profits. Retail customers also participate in the forex market, generally as speculators who are hoping to profit from changes in currency rates.

Foreign currency exchange rates may be traded in one of three ways:

1. On an exchange that is regulated by the Commodity Futures Trading Commission (CFTC). For example, the Chicago Mercantile Exchange offers forex futures and options on futures products. Exchange-traded forex futures and options provide their users with a liquid, secondary market for contracts with a set unit size, a fixed expiration date and centralized clearing.

2. On an exchange that is regulated by the Securities and Exchange Commission (SEC). For example, the Philadelphia Stock Exchange offers options on currencies (i.e., the right but not the obligation to buy or sell a currency at a specific rate within a specified time). Exchange-traded options on currencies have characteristics similar to exchange-traded futures and options (e.g., a liquid, secondary market with a set size, a fixed expiration date and centralized clearing).

3. In the off-exchange, also called the over-the-counter (OTC), market. A retail customer trades directly with a counterparty and there is no exchange or central clearing house to support the transaction. Off-exchange trading is subject to limited regulatory oversight.