We traders use the exchange rate every day but many of us don’t really know what it is or how it works, especially people without any formal Forex training – This is why I’ve decided to write an article about precisely this.
Sure, it’s not primordial to know everything about the mechanics of it (I won’t actually go into too much details), but it will help you make some sense of the market’s fluctuation.
What Is An Exchange Rate?
An exchange rate is the rate at which one currency can be exchanged for another.
You’ve probably seen many exchange booths at airports for instance. When you travel to a foreign country which doesn’t use the same currency as yours, you need to change your own money for the local currency.
The exchange rate will determine how much of the local money you can get for your own money. For instance, if you’re going from Europe to the US, you will need to buy US Dollars. The current exchange rate for the EUR/USD is 1.11. This means that for every Euro you have, you can buy 1.11 dollars.
In a way, the exchange rate is the value of another country’s currency compared to that of your own country.
Fixed Exchange Rate And Floating Exchange Rate
There are two difference ways of determining the price of a currency against another one. One way is fixed (also called “pegged”), the other is floating. Let’s describe both, and see the pros and cons of each.
Fixed Exchange Rates
A fixed rate is a rate that the government sets and maintains with the help of its central bank. The exchange rate is official and determined against one of the major currencies (usually the US Dollar but sometimes it can also be the euro or the yen).
To maintain the rate wanted by the government, the central bank needs to have a high level of foreign currency reserves. This is why the central bank will have to trade its own currency for the currency against which it’s pegged by buying and selling it in the foreign exchange market. These foreign currency reserves will be used to ensure an appropriate money supply and fluctuation in the market.
Floating Exchange Rates
The floating exchange rates are not determined by the government of its country, but rather by the simple supply and demand rules. By nature, a floating exchange rate is constantly changing. Just like any other asset, since the floating exchange rate is determined by supply and demand, it’s often self-correcting.
The central bank will intervene a lot less often in a floating regime than in a fixed regime, but it will happen. When the central bank does get involved, it is usually to ensure stability and avoid inflation.
Which one’s which?
By now you’re probably wondering which currencies are fixed and which ones are floating.
There was a time when the world used pegged exchange rates. Between 1870 and 1914, currencies were pegged to gold. Each currency had a fixed exchange rate to gold ounces. It was a time of global stability and the capital was able to move unrestricted thanks to the gold standard. The stability however got shaken by the start of World War I in 1914 and the gold standard was abandoned.
By the end of World War II, the global economy had drastically changed and Europe was in bad shape. Along came the Bretton Woods conference. To try to bring the global economic back to stability, it was decided to fix the currencies once again but this time against the US Dollar which would then in turn be pegged to the gold ounce. This lasted until 1971 when the US Dollar had to step down because it couldn’t hold the rate at which it was pegged against the ounce of gold (US$35/ounce of gold).
All major governments then adopted floating exchange rate systems. There were other attempts to go back to a global fixed rates regime, but all were abandoned by 1985. The use of gold as a peg has also been completely abandoned.
The Financial Crises of Fixed Regimes
The advantages of fixing a currency are quite obvious. It brings stability in the economy of the country and welcomes foreign investments. In a pegged regime, investors will always know how much their investment’s value is and won’t have to worry about the rates fluctuating.
That said, maintaining a peg is very difficult – this is why fixed regimes often led to big financial crises. Governments trying to maintain the value of their currency too high resulted in said currency being overvalued. The governments then couldn’t meet the demand to convert their currency into the currency at the pegged rate, the central bank’s foreign currency supplies eventually emptied and foreign investors fled the country. This is what happened for instance in Mexico. The Mexican government had to devalue the peso by 30%, which led to the Mexican crisis in 1995.
As we’ve seen, the floating exchange regime is now widely used around the world and has proven to be the most effective way of determining the value of a currency and create stability in the market. Thankfully, floating markets are also amazing for trading and Forex is no exception!
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