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Fixed and Floating Rates: Foreign Currency Exchange

Foreign Currency Exchange Fixed and Floating Rates

When entering the forex market, it is always important to familiarise yourself with all foreign currency exchange jargon.  If you do not understand the different terms, there is a great chance you will find yourself lost and confused in this highly fast-paced world.  One aspect of the forex market which must be studied is that of foreign exchange rates; not only the rates in general, but the different types of rates as well.  These include floating rates and fixed rates.

What are Foreign Currency Exchange Rates

A forex exchange rate is basically the value at which a currency can be exchange for another currency.  It is the value of a different country’ currency when compared to the home currency.

What are Fixed Rates

When examining forex rates, one will find two general types of rates: the fixed rates and the floating rates.  The fixed exchange rates are also known as pegged rates and are set by a country’s national bank to be used as their official foreign currency exchange rate.  This fixed rate is usually determined through the use of one of the major world currencies, often the US dollar or Euro.  In order to maintain the rate, the national bank will sell and buy its own currency on the forex trading market using the pegged currency as an exchange.

To better explain this process, here is an example of the strategy: a government decides the value of their local currency is equivalent to $5 and the national bank must ensure it retains sufficient foreign reserves.  The reserves are an amount of foreign currency kept by the national bank which allows it to absorb or release additional funding out of or into the forex trading market.  This ensures a suitable money supply and suitable fluctuations in the market to maintain the exchange rate at the required level.  The national bank may now adjust the exchange if it is deemed necessary.

What are Floating Rates

Unlike a fixed rate, the floating exchange rates are set by supply and demand on the private market.  These rates are often termed as being self-correcting due to any potential variance in the private market being automatically corrected.  For example, if the demand of a particular currency is low, the value of the currency will decrease.  This makes the imported goods expensive and causes a demand for goods and local services.  It causes increased employment rates acting as a job creation mechanism, which will allow for the market to auto-correct itself.  This exchange rate can be seen as constantly changing.

While there are two types of foreign currency exchange rates, no country’s currency is complete floating or fixed.  There are times when a currently will reflect a true value as compared to its fixed value causing the development of a ‘black market’ – a market which better reflects a supply and demand state.  If this should happen, the national banks have no option but to devalue or revalue the fixed rate and align it with an unofficial rate.  This will end the ‘black market’ activity.

 

 

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