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The Mechanics of FX Rates

 FX Rates

The Mechanics of FX Rates

Most people know how FX rates work as they have needed foreign currency when travelling to another country.  Obtaining foreign currency for travelling is the most basic method of exposure to this market.  The big picture of foreign currency is much wider and includes governments, central banks, large corporations, large financial institutions and retail traders.  Trillions of dollars are moved daily in this financial market and it is an extremely liquid market.  The factors that affect the currency value of a country are dependent upon several factors as well as the method of fixing the rates.

Determining the Cost

The national currency of a country determines the value of goods, regardless of which country that service or item is in.  Foreign exchange currency is important for trade in the world as it is not always possible to use your domestic country in another country.  You require an intermediary to exchange your domestic currency to the currency of the country you are visiting or doing trade with.  Without this, you would be unable to complete your business transactions.  FX rates can be described as the cost of one currency to another.

Fixed FX Rates

A fixed FX rate is the rate set by a government as to the value of their currency.  The government normally makes use of artificial means to maintain and stabilise this rate.  Governments who use this system normally peg their country’s currency to another country’s currency.  The currency will be static and will not experience any fluctuation in its rates from day to day.

Maintaining a stable fixed foreign exchange rate is quite a difficult task for any government.  The central bank of the country is required to hold large foreign currency reserves to keep up with the needs of supply and demand.  If there is a sudden increase in the demand for a specific currency, the government would need to release adequate quantities of that currency to satisfy the demand.  Likewise, if a currency’s demand declines, the central bank would have to buy back the currency that is being affected.

This type of system is normally maintained by countries with immature economies that may not be as stable as it should be.  This system is often used by developing countries in an attempt to control the rate of inflation.  If not controlled properly, the country could experience an uncontrollable level of inflation.  It is a very risky system to implement as a country may reach a stage where the foreign exchange rates are not in line with the valuation in the real world.

Floating Exchange Rates

Floating rates are determined purely by market activity.  The value of a currency is based on the perception of buyers of the currency.  It should be based on supply and demand.  Supply and demand is normally boosted by inflation, the ratios of exports and imports, investment by foreign entities and several other economic factors.

This type of system is normally used by countries with mature, stable economies.  It is considered to be a more stable method of determining the value of a currency as it takes the inflation rate and other economic factors into account.  Although it is a more stable method, it is not a perfect system as it often discourages investment if a country’s economy suffers a slight setback.  This can cause major swings in the rate and push inflation through the ceiling.

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