The definition of the 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 the 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 the 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 the same.
If you take a trip to another country and you have to pay for something in that country’s currency, you have to pay attention to the different rates.
Because of the different rates 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 in 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 of how to determine the currency exchange rate they are:
- Fixed exchange rate
- Floating exchange rate
Fixed Exchange Rate
A Fixed Exchange rate or fixed rate is the rate set by the central bank of the country. This type of rate is also known as the pegged rate.
To determine the rate, the central bank pegs the local currency with any strong currency such as the dollar, euro or pound.
And the central bank is responsible to maintain the local exchange rate. Thus, the local currency continues to rise and fall with a 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, the terms of trading remain fairly stable.
- If the economy in the international market has fluctuated, then the country which adopts the fixed-rate system will not be affected.
The disadvantage of a fixed rate is:
- The fixed-rate does not have an 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 the market price. Free market forces of demand and supply in determining the value of the currency.
The advantage of floating rate is:
- The 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 rating system.
- The demand for 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 inflation. The central bank has to control inflation by changing the interest rate.
- The rate continues to change, therefore costs of exports and imports of the country change accordingly
In most cases, floating-rate will use by countries with a mature and stable economic market.
The performance of the currency exchange rate affected by a number of economic forces. So, the 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 that 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 works to control all those factors as far as possible. So the Reserve bank provides the best environment for the economy that functions properly and effectively.
Your knowledge about the exchange rate would be very helpful if you decide to get into the Forex trading market.