Forex Exchange rates define how much a particular currency is worth vis-à-vis the currency of another country. Broadly speaking, there are two ways of determining exchange rates, namely fixed (or pegged) rates and floating rates. There is a rich history surrounding forex exchange rates, from there being a global exchange rate between 1870 and 1914 to the emergence of floating rates.
Forex Fixed Exchange Rates
A fixed exchange rate is one that is set by the government, usually the central bank, and is then maintained as the official exchange rate. This set price is then valued against a key world currency, such as the US dollar, the euro and the yen. The central bank buys/sells its own currency in the foreign exchange (Forex) market against the currency to which it is pegged to maintain the exchange rate. This is why such exchange rates are also known as pegged rates. For instance, China’s currency, the yuan renminbi (RMB), was pegged/fixed to the United States dollar at RMB8.2768 to $1 between 1994 and 2005.
Currency rates are fixed with the objective of maintaining the local exchange rate. Countries with fixed exchange rate regimes are often those that have an unsophisticated capital market, along with a weak regulatory system.
The central bank keeps foreign exchange reserves to either infuse or absorb extra funds from the market to ensure appropriate money supply in the economy. Although the exchange rates are fixed by the central bank under this system, the bank may adjust the official exchange rate as and when it deems necessary.
Forex Floating Exchange Rates
Under the floating rate system, the private market determines the value of a currency. This system is also called a flexible exchange rate regime, since the value of a particular currency is allowed to fluctuate according to the demand/supply trends in the foreign exchange rate market. A forex floating rate is constantly changing and, as a result, uncertainty around the value of a currency is inherent to this system.
In extreme cases, under this system, the central bank may intervene in order to provide stability to the currency and investment into the economy of a particular country. Thus, a floating rate regime is often termed as a managed float system.
Usually the countries that have a more mature and a stable economy prefer the floating rate system. This system is considered to be efficient because an auto-correction in the value of a currency takes place to reflect inflation and other economic variables.