What Exchange Rates Exactly Are?
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.