If you are involved in forex trading, exchange rates are something that you will think about very regularly throughout each trading day. However, if you are a new trader, or someone looking in from the outside, you may be wondering what exchange rates are and why they even matter.
These are both points we will take to give you a clearer picture of the function of exchange rates and why they are so important.
The basics of an exchange rate
From a very simple perspective, one exchange rate tells the value of one currency against another. So the exchange rate is what you will use if you want to know how much 1 Euro will cost in US dollars for example. Taking this example to the exchange 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 always fluctuates based on the market and trade within that market, which effectively sets the price for each currency. There are a number of drivers when it comes to exchange rates for certain currencies. These include not only the country’s economic outlook but other factors such as social, domestic and geopolitical environments. All of these factors are reflected in currency trading in the foreign exchange market, which is open 24 hours a day, 5 days a week. This is the largest financial market currently traded in the world, with values exceeding $ 5 trillion daily.
How important is the exchange rate?
The exchange rate is important for several reasons. First, you may think that the exchange rate does not affect you if you are not engaged in forex trading. This is not the case. A very common example of how exchange rates can affect your personal finances if you take a vacation or travel to the US from Europe or vice versa. If you come from Europe and the dollar is strong, your euro will actually buy you more US dollars. This will provide a cheaper journey overall. The same is true in the opposite direction.
At a broader level, the strength of a currency and exchange rates can have a major impact on the cost of import and export. This leads nations to prioritize the stability of their currency, especially against the USD, which can enhance their trade potential. Exchange rate stability between major trading partners such as the US and the EU is crucial for the entire economy.
With regard to forex brokers and traders in the market, exchange rates take on a different meaning as the market enters into a number of different trades where exchange rate fluctuations can bring profits and losses to the traders.
Different types of exchange rates
If you look at a foreign exchange rate, you can assume that there is only one type of exchange rate. In fact, this is not the case either. There are several types of exchange rates that can mainly be placed in two categories, a flexible exchange rate and a fixed exchange 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 exchange rate moves freely based on the forex market’s powers and the trading that takes place.
With a flexible interest rate, there is no direct intervention by a government to set the value of the nation’s currency. There are, of course, a number of influences on flexible exchange rates, and the government’s fiscal policy plays a role here. That said, politics generally affects an exchange rate over a longer period of time and in an indirect way.
Fixed exchange rates
A fixed exchange rate is one that rarely moves. This can be for a number of reasons, although these are often set and regulated by the government of these countries. These countries’ currencies are typically linked to the US dollar within a certain range.
To maintain this range against the Dollar, central banks in these countries typically have 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 closely monitor the movement of currency both in and out of the country in most cases. The Hong Kong Dollar is an example of a currency bound to the USD, while the Chinese Yuan is also quite strictly controlled and does not move nearly as often as a flexible exchange rate currency.
Factors that may affect an exchange rate
There are many key factors that can affect the exchange rate of a particular currency. A country’s general economic situation is typically one of the major factors in determining its exchange rate. When a nation has a strong, positive period of economic growth, this generally meets with an increased investment amount and more holdings of that currency. By and large, a strong currency is indicative of good economic conditions in this country (There are some safe harbor currencies like USD and JPY that can prove the exception here).
The interest rate of a country also has a major influence on the strength of the currency and the exchange rate. If a country has a high interest rate, this currency is generally considered more valuable and it is bought by investors for the purpose of increasing the return through the higher interest rate.
Another important factor when it comes to exchange rates is the supply of a currency. This must be carefully monitored, as an excessive supply of currency can greatly undermine it and cause prices to fall and inflation to rise as a currency becomes less valuable, the more available in relation to demand.