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If you are involved in forex trading, then exchange rates are something that you will think of on a very regular basis throughout each and every trading day. If you are a new trader though, or someone looking in from the outside, you may wonder exactly what exchange rates are, and why they even matter.
These are both points we will address in giving you a clearer picture about the function of exchange rates, and why they are so important.
Basics of An Exchange Rate
From a very simple perspective, an exchange rate tells you the value of one currency against another. So, the exchange rate is what you will use if you wish to know how much 1 Euro will cost in US Dollars for example. Taking that example at the rate for today, 1 Euro would be worth $1.12, so if you want to buy 1 Euro, this will cost you $1.12.
This exchange rate value is always fluctuating based on the market and trade within this market which effectively sets the price for each currency. There are a variety of drivers when it comes to exchange rates for particular currencies. These include not only the economic outlook of the country, but other factors too such as social, domestic, and geopolitical environments. All of these factors are reflected in the trading of currencies on the forex market which is open 24 hours a day, 5 days per week. This is the largest financial market traded in the world currently, with values exceeding $5 trillion traded on a daily basis.
How Important is the Exchange Rate?
The exchange rate is of key importance for a number of reasons. Firstly, you may think that the exchange rate does not impact you if you are not engaged in forex trading. This is not the case. A very common example of how the exchange rates can impact your personal finances is, if you are taking a vacation or trip to the US from Europe or vice versa. If you are coming from Europe and the Dollar is strong, then your Euro will actually buy you more US Dollars. This will make for a cheaper trip overall. The same is true in the opposite direction.
On a wider level, the strength of a currency and exchange rates can have a great impact on the cost of imports and exports. This leads nations to prioritize the stability of their currency, particularly against the USD which can improve their potential for trading. Stability of exchange rates between major trading partners then like the US and EU is vital to the entire economy.
In terms of forex brokers and traders in the market, exchange rates take on a different significance since the market is entered into a variety of trades where the fluctuations in exchange rates can bring profits and losses to traders.
Different Types of Exchange Rates
Looking at an exchange rate, you may presume that there is only one type of rate. In fact, this is also not the case. There are several types of exchange rates which can be mainly placed into two categories, a flexible rate, and a fixed rate.
Flexible Exchange Rates
The vast majority of exchange rates in the world are flexible. This certainly applies to any of the major currencies that you will encounter in forex trading. A flexible exchange rate means that the rate moves freely based on the powers of the forex market and the trading that takes place.
With a flexible rate, there is no direct intervention from a government to set the value of the nation’s currency. There are of course a number of influences on flexible exchange rates, and government fiscal policy plays a role here. With that said, policy generally influences an exchange rate over a longer period of time, and in an indirect manner.
Fixed Exchange Rates
A fixed exchange rate is one which rarely moves. This could be for a number of reasons, though most commonly these exchange rates are set and regulated by the government of their countries. The currency of these countries is typically pegged to the US Dollar within a certain range.
In order to maintain this range against the Dollar, the central banks of these countries typically hold enough US Dollars in reserve which they can then exchange for the local currency to reduce circulation and maintain a certain value. They will also tightly control the movement of currency both into and out of the country in most cases. The Hong Kong Dollar is an example of a currency pegged to the USD, while the Chinese Yuan is also quite strictly controlled and does not move nearly as frequently as a flexible exchange rate currency.
Factors that May Affect an Exchange Rate
There are many key factors which may affect the exchange rate of a particular currency. Typically speaking, the general economic situation of a country is one of the biggest factors in determining its currency rate. When a nation has a strong, positive period of economic growth, this is generally met with an increased amount of investment and more holdings of that currency. Broadly speaking then, a strong currency is indicative of good economic conditions in that country (There are some safe-haven currencies like the USD and JPY which can prove the exception here).
The interest rate of a country also has a big influence on the strength of the currency and exchange rate. If a country has a high interest rate, then that currency is generally considered more valuable and it will be bought by investors with the intention of increased returns through the higher interest rate.
Another major factor when it comes to exchange rates is the supply of a currency. This has to be carefully controlled since an oversupply of currency can greatly undermine it and lead rates to drop and inflation to increase as a currency becomes less valuable the more that is made available relative to demand.
Anthony is a financial journalist and business advisor with several years’ experience writing for some of the most well-known sites in the Forex world. A keen trader turned industry writer, he is currently based in Shanghai with a finger on the pulse of Asia’s biggest markets.