What is a Foreign Exchange Rate?

If you have ever travelled overseas and needed to purchase foreign currency to use in the country you are visiting then you will probably be familiar with the term “exchange rate”. An exchange rate is basically the rate at which any one particular currency can be exchanged for another currency. If, for example, you were travelling from the United States to France then you would need to purchase Euros (€). If the exchange rate of the Euros to the US dollar ($) was 0.7500 then for every $100.00 you exchanged, you would receive €75.00

As Forex trading is all about the buying and selling of foreign currencies, the exchange rates of difference foreign currencies is extremely relevant. Each time you make a trade you will be taking a position on how the value of one particular currency performs relative to another currency; in Forex trading you always trade currencies in pairs. Before entering a trade, you will need to look at the current exchange rate by examining the Forex quote. You can read more about Forex quotes on the page at Understanding Forex Quotes. There are two ways in which the price of a currency is determined in relation to another – a fixed exchange rate or a floating exchange rate.

Exchange Rate Regimes

A country can choose to have one of two exchange rate regimes for its currency – fixed exchange rate or floating exchange rate. A fixed exchange rate (also referred to as a pegged exchange rate) is where the government sets an official exchange rate against either a single major world currency (such as the US dollar) or a basket of foreign currencies. A floating exchange rate is where the value of the currency is allowed to fluctuate according to movements in the Forex market. Throughout history, exchange rates have often been fixed while these days major currencies are mostly floating.

What is a Fixed Exchange Rate?

When a government is using a fixed exchange rate regime, they would maintain that fixed exchange rate by buying and selling their own currency on the open market through their central bank. If the actual exchange rate starts to move below the set rate, then the government would buy its own currency using to increase demand in the market and move the price of the currency up. Should the exchange rate move above the set rate, then the government would sell its own currency to move the price of the currency down. Governments that use a fixed exchange rate regime need to ensure that their central bank maintains a high level of foreign reserves. Foreign reserves are foreign currency that is held by the bank that can be used, as required, to control the exchange rate.

Historically, there have been global fixed exchange rates. In the period between 1870 and 1914, the gold standard was in force and the price of any particular currency was fixed at a set exchange rate in relation to gold. This allowed for worldwide stability in the value of currencies and assisted international trade. However the outbreak of the First World War led to the gold standard being abandoned. Global currencies were again fixed after then end of World War II, as part of the Bretton Woods Agreement. This time around, currencies were pegged to the US dollar and effectively controlled by the International Monetary Fund (IMF). This practice ceased in 1971 and since then most major governments have adopted the floating exchange rate regime. What is a Floating Exchange Rate?

Where a country is using a floating exchange rate regime, the value of their currency is not controlled by the government or central bank but fluctuates naturally relative to market forces. If a currency is under a floating exchange rate regime it is known as a floating currency. There are many economists who believe that floating exchange rates are preferable to fixed exchange rates as they better reflect market forces. Others may argue that that a floating exchange rate leads to greater foreign exchange volatility which could cause economic problems – particularly in emerging economies.

Although the majority of the currencies in the world are floating currencies, it is still not uncommon for central banks to intervene to stabilize a currency in times of significant appreciation or depreciation. Some governments may define upper and lower limits, between which they allow the price of their currency to move freely. Should the price of their currency move out of those limits, then they will take action to move the price back. This is known as managing the float.

Summary

The fixed exchange rate regime certainly had its benefits, and has worked well in the past by creating global stability and assisting international trade. However, this stability was only brought about by all the major economies partaking in a fixed exchange rate regime. The floating exchange rate regime is not without its downsides, but in the modern world most major currencies are floating. Floating exchange rates are directly influenced by market forces and as such provide a clear indication of the long term value of currencies.

It could also be argued that floating exchange rates help create more of an equilibrium in the market as a whole. It is vital to a traders success that they become very familiar with forex fundamentals. This will help ensure a trader's ability to be as efficient and profitable as they can possibly be.