All About Exchange Rates

An exchange rate is an outlay at which one currency will be exchanged for another currency and affects trade and the movement of money between countries. It is categorised by the value of one currency denomination for another. The exchange rate between two currencies is determined by a number of factors such as the economic activity, interest rates in markets , gross domestic product, and unemployment rate in both countries and can either operate in a fixed or floating exchange rate control environment.

Fixed Exchange Rates

Under a fixed exchange rate regime, the government or central bank determines and maintains a constant exchange rate between two currencies. This process involves several steps as follows:

• A reference currency, (generally a major market currency such as the US Dollar or the Euro), is selected by the central bank. The domestic currency is then pegged to this reference currency at a fixed exchange rate called the par value. Although the central bank could fix this at any rate, it is generally set at an expected fair value taking into account the economic conditions of the country.
• To maintain the fixed exchange rate, the central bank performs a number of interventions in the foreign exchange market in an attempt to maintain the pegged value by buying or selling  its own currency using foreign currency reserves to maintain the value. These interventions aim to stabilise the exchange rate. However, excessive interventions can deplete foreign currency reserves, making it challenging for the country to conduct trade.
• In addition to interventions, countries with fixed exchange rates may implement capital controls. These controls restrict the flow of capital in and out of the country, preventing speculative attacks or capital flight and maintaining exchange rate stability.
• Governments may also make policy adjustments to support the fixed exchange rate regime. These adjustments can include changes in interest rates, trade policies, or fiscal reforms. The objective is to ensure the stability of the fixed rate and align it with the country’s economic conditions.

Floating Exchange Rates

A free floating exchange rate system is characterised by a market-driven determination of currency values. The exchange rate is determined by the foreign exchange market, where buyers and sellers interact based on the forces of supply and demand. Unlike a fixed exchange rate regime, there is no fixed reference point or predetermined value to which the currency is pegged. Instead, the exchange rate is influenced by various factors such as interest rates, inflation, economic indicators, and geopolitical events which often results in the natural volatility of the rate which may require government interventions.

This volatility also allows for automatic adjustments in the exchange rate depending on the condition of the countries market. If a country experiences increased exports or attracts foreign investment, its currency may appreciate. Conversely, if the country faces economic challenges or trade deficits, its currency may depreciate. This automatic adjustment mechanism helps align the currency’s value with the underlying economic fundamentals.

A free floating exchange rate system promotes market efficiency and flexibility. It allows currencies to reflect the true economic conditions of a country and enables independent monetary policy decisions. Countries have the flexibility to adjust interest rates and implement policies to address domestic economic conditions.

While the volatility of free floating exchange rates poses risks for businesses engaged in international trade, it also presents opportunities for hedging and risk management. Financial instruments such as forward contracts, options, and currency swaps can help businesses manage the risks associated with fluctuating exchange rates.

Exchange rates are key to the success of international trade as they allow people from different countries to trade without the barrier of different national currencies. They also help countries influence the direction they want their economies to take with export or import.