Forex Market: What are currency exchange rates?

An exchange rate is defined as the value of one country’s currency against that of another country or economic zone. For example, the amount of US dollars needed to buy one euro or how many Japanese yen it takes to purchase one British pound. Currency exchange rates can be floating, meaning they continue to change based on a number of different factors, or pegged, whereby one currency is fixed to another, moving together in tandem. Learning about currency exchange rates and what affects them is essential for forex traders. Traders can trade fx with a forex broker, taking advantage of tight spreads and downloading the standard forex platform, MT4.

Floating exchange rates

A floating exchange rate system is where a currency’s value is determined in relation to other currencies. They are not restrained by government controls or trade limits; hence they float freely, determined by supply and demand on the open market. Short term movements in this type of exchange rate are the result of a number of factors – from speculation and disasters to everyday supply and currency demand. Currencies that are floated can be perceived as either strong or weak, depending on the market sentiment towards that country’s economic situation. Political factors also play a role too, as a currency’s value can depreciate if the country’s government is viewed as unstable.

Fixed exchange rates

A fixed exchange rate, also known as a pegged exchange rate, is where countries value their currency in the world market by fixing or pegging their currency to other currencies and commodities, such as gold. To maintain this type of exchange rate, a country’s central bank must ensure the maintenance of a high level of currency reserves. The rate can be particularly advantageous to the smaller country as it facilitates trade and investment between the two countries whose currencies are pegged. For instance, many smaller nations have pegged their currency to the US dollar, including Cuba, Ecuador, Qatar, Saudi Arabia and Venezuela, to name a few.

History of the exchange rate

At the turn of the 20th century, currencies were linked to physical gold, as part of a fixed exchange rate network across the world. This meant that the value of local currency was in fact fixed to gold ounces at a specified, set exchange rate – known as the gold standard. Under this system, global countries agreed to paper money being converted into a fixed amount of gold. The gold standard was abandoned following the outbreak of World War I, but a fixed exchange rate was returned to in 1944 as the result of the Bretton Woods Conference. At the meeting of international delegates, the International Monetary Fund (IMF) and the World Bank, while guidelines for a fixed exchange rate system were set out. A gold price of $35 per ounce was imposed under the new system, with the participating countries choosing to peg their currencies to the US dollar.

Around three decades later, the system had collapsed in ruin, after a serious devaluation in 1967 and the United States withdrawing from the gold standard four years later. By 1973, the participating countries were freely able to float their currencies, instead of operating as part of a fixed rate system – except for pegging the value to the price of gold.

The Bretton Woods Agreement was a significant moment in the world’s recent financial history, as it helped to rebuild the economies of Europe in the aftermath of World War II. Also, the establishment of the IMF and World Bank was particularly important, as they continue to serve as prominent institutions. The IMF oversees the stability of the world’s monetary system, while the World Bank’s central purpose is to promote economic and social progress in developing countries by helping to raise productivity.

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This information is not considered as investment advice or an investment recommendation, but is instead a marketing communication

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