When you look at trading on the forex market you need to know how foreign exchange rates are calculated. There are two main economic systems that are used on the foreign exchange rates. These systems are the floating and the pegged rate. It is important that you know what the differences are and how they affect your trading.
The Cost of Money
Modern economies depend on national currencies to determine the value of an item irrespective of which country it is in. Foreign exchange rates are important since one country’s currency is not always classified as legal tender in another country. It is not possible for you to walk into a store in Sweden and pay for your goods with Japanese yen. However, this is of no consequence when you are trading on the forex market. When you trade you need to know what the foreign exchange rates are to make a profit. You also have to know what system is being used so you can determine what will move the market.
The Floating Foreign Exchange Rates
This rate is determined by the market. A currency is normally worth whatever the buyers out there perceive its worth to be, based on demand and supply. Demand and supply is driven by inflation, the ratios of imports and exports, foreign investment and many other economic determinants.
Countries that experience stable, mature economic markets will generally make use of this system as it is considered to be more efficient because the market adjusts the FX rates by taking into account economic situations and inflation. This is not a perfect system as it will not encourage investment if the economy of a country suffers a setback. This could cause investors to experience major swings in the FX rates and send inflation through the roof.
The Pegged Rates
This is also known as a fixed system. This is a system where the FX rate is set and the government uses artificial methods to maintain that rate. The rate is normally pegged to another country’s currency and will not experience any rates of fluctuation from one day to the next.
It is not an easy task for a government to maintain a stable pegged rate. It will be necessary for their central bank to maintain large reserves of foreign currencies to ride the wave of supply and demand. In the event that there is a sudden demand for a particular currency, it would be up to the government to release sufficient quantities of that particular currency to meet the hike in demand. Similarly, if the demand for a particular currency drops, it would be up to the central bank of the country to buy back the affected currency.
This system is generally used by countries that have immature economies that may be unstable. Developing countries often make use of this system to try and prevent the level of inflation from becoming uncontrollable. This system is risky as the country may reach a point where the FX rates in the real world are not reflected by the rate that the country has pegged.