International currency exchange rates determine how much of one currency can be traded for another. Exchange rates can either be floating or pegged. Floating currency exchange rates change perpetually as a result of various factors. Pegged currency exchange rates are fixed alongside another currency.
Understanding the value of one currency in comparison to other foreign currencies is vital when trying to analyze assets priced in foreign currencies. Knowing the exchange rate of multiple currencies can allow you to make smart, well-timed investments.
The following article will delve deeper into who decides the currency exchange rates and how these work across the globe.
Floating vs. Fixed Exchange Rates
There are two primary methods of determining currency prices. A floating rate is governed by the open market and changes based on supply and demand. When demand for the currency rises, so does the value of the currency. When demand lowers, the value drops. Supply and demand are determined by a series of complex factors.
The other primary way of determining currency prices and exchange rates is known as a fixed or pegged rate. This rate is established by the government via its central bank. The rate is based on another major currency. In order to keep the exchange rate at a consistent level, the government buys and sells its currency against its pegged currency. China and Saudi Arabia are examples of two currencies that peg their interest rates to the USD.
The majority of the world’s major economies do not operate with a pegged exchange rate. Instead, these exchange rates can change freely according to market activity.
Factors That Impact Exchange Rates
Floating exchange rates change depending on market forces. The demand for a currency compared to its supply determines its value. World news can affect the exchange rates between two countries. Factors such as unemployment rates, inflation reports, interest rate changes, and manufacturing data can affect the exchange rate between two countries.
If the supply of a currency is higher than the demand, the value of the currency will decrease. Conversely, the opposite is also true. If demand is higher than supply, the value of the currency rises.
Central banks may sometimes intervene when extreme short-term moves have profound implications even in floating rate exchange rates. If a country’s currency rises too high or drops too low, the government has the power to step in. The reason for this is that currency that changes too drastically can negatively affect the nation’s economic standing, in turn affecting trade and debts.
Macro Factors
Macro factors can also have an impact on exchange rates. An economic theory known as the ‘Law of One Price’ states that goods should hold equivalent values regardless of currency. As such, interest rates and relative prices have some bearing on exchange rates. As well as this, geopolitical risk and a nation’s stability also has an effect.
Forex and Commodities
As a rule of thumb, the more reliant a country is on a single domestic industry, the stronger the correlation will be between the currency of that nation and the price of the domestic industry’s commodity.
As the price of that commodity rises, so too does the currency’s value compared to other currencies, in turn affecting the exchange rate. This is often a good indicator of expected increases and decreases in the value of a country’s currency.
If a country’s primary export rises in value, its currency is likely to follow suit as a direct result of this.
Maintaining Rates
For countries that use a pegged exchange rate system, the government is responsible for maintaining currency exchange rates artificially. These rates do not fluctuate day by day and are often reset on revaluation days. This is frequently done by the governments of emerging market nations in order to establish stability with regard to the currency’s value.
In order to be able to do this, these governments must have sizable reserves of the pegged currency. This helps manage shifts in supply and demand.
Summary
As you can see there are many factors that affect currency exchange rates. In most cases, it is the natural slow of supply and demand that determines a currency’s exchange rate. At least this is true when it comes to floating currencies.
For pegged currencies the value is determined by the central government, and this form of currency control can be used to bring artificial stability to an otherwise volatile market.
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