Definition of exchange rate is the value of one country’s currency with reference to the currency of another country. Or in other words it is also known as foreign exchange rate is described as the rate at which one currency can be traded to another currency.
Just like every product or service that has its own price, actually the exchange rate is the price of a currency itself. This means that a specific country’s currency has a specific value if we compare it to another country’s currency.
For example, the rate of British pound to Australian dollar is 0.63. And that means that 1 AUD is equal to 0.63 British pounds. The value or worth of 1AUD and 0.63 British pounds is same.
If you take a trip to another country and you have to pay something in that country’s currency, you have to pay attention of the different rates.
Because of the different rate from one country to another country, there is a difference between the buy and sell that Forex trader can make money.
Type of Exchange Rate
The Forex rates fluctuate every day, even in a small value. Depending on what is going on in economic and international trading, therefore the Forex rates can go up and down dramatically.
The changes of rates influenced or determined by lots of factors. But these factors can be classified under government intervention and market forces.
Maybe you think about how to determine the rates and also what the advantages or disadvantages are. There are two types how to determine currency exchange rate that are:
- Fixed exchange rate
- Floating exchange rate
Fixed Exchange Rate
Fixed Exchange rate or fixed rate is the rate that set by the central bank of the country. This type of rate is also known as pegged rate.
To determine the rate, the central bank pegs the local currency with any strong currency such as dollar, euro or pound.
And the central bank is responsible to maintain the local exchange rate. Thus, local currency continues to rise and fall with the strong or pegged currency.
The advantages of fixed rate are:
- Because of the fixed rate, prices of exports and imports of the country do not change rapidly. Therefore, terms of trading remain fairly stable.
- If the economic in the international market has fluctuated, then the country which adopts the fixed rate system will not be affected.
The disadvantage of fixed rate is:
- The fixed rate does not have the automatic mechanism. Because this mechanism is required to adjust the changes in demand and supply of the currency.
Fixed rates or pegged rates are rarely used. However, small countries with economies dependent on foreign trade usually use this type.
Floating Exchange Rate
This type of exchange rate that the currency is driven by market price. Free market forces of demand and supply is determining the value of currency.
The advantage of floating rate is:
- Floating rate can automatically adjust any difference in the supply and demand of the currency. And of course this is the main advantage of the rate system.
- The demand of the currency will automatically rise when the country’s demand for import is stronger than the supply of its export and vice versa.
The disadvantages of floating rate are:
- This system causes the inflation. The central bank has to control the inflation by changing interest rate.
- The rate continues to change, therefore costs of exports and imports of the country changes accordingly
In most cases, floating rate will use by countries with mature and stable economic market.
The performance of currency exchange rate affected by a number of economic forces. So, interest rate is the most major driver of the rate. If there is a change, then the interest rate will directly change the rate.
There are some major factors which influence the exchange rate. Including:
- The country’s financial stability
- The central bank’s policy
- Trade flows and equity
- Foreign investments
Each country has a reserve bank that work to control all those factors as far as possible. So the Reserve bank provides the best environment for the economy that function properly and effectively.
Your knowledge about exchange rate would be very helpful if you decide to get into Forex trading market.