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Home  >  Trading basics  >  Forex exchange rate

Forex exchange rate

Foreign exchange rate is the value comparison between two different currencies. In currency trading, an exchange rate will tell you how much you need to pay in currency X in exchange for a fixed number of unit of currency Y. For example, when you see something like USD/GBP, it basically means how much you need to pay in GBP to buy 1 USD. In a currency pair like this, the first currency is the base currency and its value is always 1, hence the other currency is calculated in relation to the base currency.

Foreign exchange rate is determined by various economic, political and market sentiments, but another simpler way to sum it up is supply and demand. Based on the example above, if the demand for GBP goes up, so will its worth, assuming that its quantity stays the same. In this situation, the GBP rate has increased against USD. Based on the same principle, if the U.S government continued to print more money (increase of supply) but the market do not prefer to hold USD (reduced demand) due to Fed's decision to cut interest rate, USD value will be lower compared to other currencies.

Because currency values hold significant impact to a country's economy, it is a normal practice for central banks to intervene and manage their currency to be within a 'safe' range. They can do this either by regulating their currency supply in the market or by adjusting interest rates. A higher interest rate will attract investors to hold their money in a particular currency, creating high demand. Similarly, no investor will want to hold a currency that is likely to devalue, is from a country with high inflation rate or belongs to a country that is plagued by political or economic turmoil. Such are the factors that can influence foreign exchange rate.

There are two major systems of foreign exchange rate, namely fixed exchange rate and floating exchange rate. Under fixed exchange rate, a currency could either be hard peg or soft peg to another stronger currency. Some smaller countries have adopted the USD as their reserve backing their own currencies, so the exchange rate between their currencies and USD is fixed. In the past, a pool of European country including Denmark, U.K and Sweden has established a currency union among themselves, which will see their currencies fixed by using the Euro. This is known as hard peg. A soft peg is when a country reserves its right to adjust its own currency by a small margin but still remained pegged to a major currency. An example of a soft peg, otherwise known as 'adjustable fixed rate' is the Bretton Woods Agreement.

Floating rate system can be categorized as free float or independent float, as well as dirty or managed float. A free float is when a currency is purely determined by the supply and demand forces while a managed float is when central banks attempt to manipulate their currency to fall within a controlled range. According to G. S. Gupta in his book 'Macroeconomics', "No country in the world is currently on a pure flexible rate system, for no central bank allows its currency to fluctuate with complete freedom." The level of control a central bank has over its currency value depends on the amount of foreign reserves it holds. India is an example of a country with significant foreign reserves to be able to stabilize their currency.

Although all of these systems have it's weaknesses, countries around the world will have to adopt one that work best for them. From an investor's point of view, learning about the background of currencies such as its national foreign reserve and foreign exchange policy will help one make more accurate decisions when trading.

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