You hear about foreign exchange market, FX, forex, exchange rates etc everyday but things aren’t exactly clear for you. Here are some pieces of information that will hopefully help you understand these quite confusing terms.
The first thing you should understand is what exactly an exchange rate is. A simple definition of the exchange rate sounds like this: a rate for exchanging one currency for another. The exchange rate is the price of a currency, like every product or service has its own price. This means that a certain country’s currency has a certain value compared to another country’s currency. You need to be aware of the different exchange rates whenever you travel to another country and you have to buy that country’s currency. For instance, if you are from France and you travel to the U.S.A and the exchange rate is 1.10 dollars for a Euro, this means that you can buy a bit more than a dollar for your Euro.
If you are worried about how much you can buy for your currency in another country, you should know that one product’s price should theoretically stay the same, regardless the currency it is used to evaluate its value. The reason for this is that the exchange rate is keeping the keeping the value of the currency at its own level.
If you are wondering about the way this exchange rate is being calculated, you should know there are two methods that are being used for this. The first method is the fixed rate. This fixed rate is being set and maintained by a country’s central bank and it is considered to be the official exchange rate for that certain currency. The price level for the currency is being determined by comparing it to a major currency like the Euro or the US dollar. The central bank is buying and selling its own currency in order to keep the exchange rate at the level which has been previously set.
Another method for setting the exchange rate for a currency is the ‘floating’ method. This method is determining the exchange rate by using the supply and demand balance for that currency on the private market. This type of exchange rate is sometimes called ‘self-correcting’ because the market is automatically correcting the differences between the supply and the demand for the currency. This kind of exchange rate is constantly being modified based on the supply and demand levels.
It may seem like the floating exchange rate is closer to the real value of a currency because the price is being determined by the supply and demand for that currency. This is not entirely correct as this kind of exchange rate is very sensible to speculations. The black market may strongly influence the exchange rate for the currency. Therefore, a fixed regime should be also applied as it permits the market to put pressure on the exchange rate.
In conclusion, no exchange rate is being determined entirely on a fixed or floating method. A combination of these two methods is normally used to set the price for a certain currency for an accurate value of the currency.
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