Understanding Foreign Currency Exchange Rates

Understanding Foreign Currency Exchange Rates

Before you can successfully trade on the forex market you have to understand the foreign currency exchange rates.  To do this you should learn about what foreign currency exchange rates are, the different systems that can be used and why certain systems are used.  You should also consider what can affect the exchange rate and how this could affect your currency trading.

What are Foreign Currency Exchange Rates

The foreign exchange rate or forex rate is the price in one currency that you would pay for a different currency.  This is displayed in trade as pairs such as NZD/USD which is the New Zealand dollar to the US dollar.  In this case you will receive the quote for US dollars in Australian dollars at a NZD: USD rate.

Floating or Fixed Currencies

Currencies can be classed as floating or fixed.  However, the majority of currencies will be floating as this is a system which has many benefits.  Floating currencies are subject to fluctuations depending on the demand for the currency.  The greater the demand for a currency the more it will cost.  Countries have been known to change their currencies from floating to fixed to stop the exchange rate from fluctuating.  This act is known as pegging and can be seen when looking at the Chinese currency.  To maintain this fixed rate countries will buy or sell large amounts of their currency or increase and decrease interest rates.

Why Floating Currencies are Used

There are many reasons why a country would have a floating currency.  One of the benefits is that a floating rate will free the interest rate which allows this to be used to tackle other aspects of the economy such as inflation.  If there are more imports then exports in a country having a floating currency can solve the problem.  The more imports which come in, increases the amount of the currency on the foreign market and this lowers the demand for it.  As a result the cost of imports will be greater and the cost of exports will be cheaper.  A floating currency is also less work for a government which is what most governments will look for.

Why Fixed Currencies are Used

Having a fixed currency can help a country in a number of ways.  If the country does not have capital markets which are very sophisticated and the governing bodies are weak a fixed currency can create a stable environment.  This stable environment will be attractive to potential investors in the country and this will lead to greater prosperity.

The Factors that Affect Foreign Exchange Rates

The interest rate is one factor which affects currency.  Many people purchase currency from a country with a higher interest rate then their own in order to lend to people and profit from the higher rates.  A higher interest rate will increase demand for the currency which increases the value.

Inflation also affects the currency as it eats away at the true value.  Lower inflation will draw more investors and increase the value of the currency.  The strength of the country’s economy plays a large role.  If the economy is strong the demand for the currency will increase making the value of the currency greater.

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