International currency exchange rates show how much one unit of one currency can be worth in another. Currency exchange rates can either be floating, in which case they fluctuate constantly based on a variety of circumstances, or pegged (or fixed) to another currency, in which case they float but move in lockstep with the pegged currency.
Investors can examine assets priced in foreign dollars by knowing the value of their native currency in respect to various foreign currencies. Knowing the dollar to euro exchange rate, for example, is useful when choosing European investments for a US investor.
A falling US dollar may enhance the value of your overseas investments, while a strengthening US currency may decrease the value of your international investments.
Exchange Rates: Floating vs. Fixed
A floating rate or a fixed rate are the two basic methods for determining currency pricing. The open market determines a floating rate based on supply and demand in global currency exchanges.
As a result, if there is a great demand for the money, its value will rise. If demand is low, the price of that currency will fall. Of course, a number of technical and basic factors will influence what individuals consider to be a fair exchange rate, causing supply and demand to shift correspondingly.
Following the fall of the Bretton Woods arrangement between 1968 and 1973, most of the world’s major economies’ currencies were permitted to float freely. As a result, most exchange rates are decided by ongoing trading activity in the global currency markets, rather than being set.
Exchange Rate Influencing Factors
The market dynamics of supply and demand determine floating rates. A currency’s value in respect to another currency is determined by how much demand there is in ratio to supply.
If European demand for US dollars rises, for example, the supply-demand relationship will lead the price of the US dollar to rise in comparison to the euro. Interest rate changes, unemployment rates, inflation statistics, gross domestic product estimates, manufacturing data, and commodities are just a few of the many geopolitical and economic pronouncements that affect exchange rates across countries.
The government, through its central bank, determines a fixed or pegged rate. The rate is determined by comparing it to another major foreign currency (such as the U.S. dollar, euro, or yen).
The government will buy and sell its own currency against the currency to which it is tied to maintain its exchange rate. China and Saudi Arabia are two countries that have chosen to peg their currencies to the US dollar.
A currency that is either too high or too low may have a detrimental impact on the economy, impacting trade and the ability to pay obligations. The government or central bank will try to put in place measures to lower the price of their currency.
Exchange rates are influenced by a variety of macro factors. In a world of international trade, the ‘Law of One Price’ states that the price of a good in one country should be the same as the price in another. Purchasing price parity is the term for this (PPP).
If prices become out of whack, a country’s interest rates will alter, or the currency exchange rate will change. Of course, reality does not always follow economic theory, and the law of one price does not always apply in practice due to a variety of circumstances. Interest rates and relative prices will still have an impact on exchange rates.
Another macro factor is geopolitical risk and a country’s government’s stability. If a country’s government is unstable, its currency is likely to depreciate in comparison to more developed, stable nations.
Commodities and Forex
The stronger the link between the national currency and the industry’s commodity prices, the more dependent a country is on a primary domestic industry.
There is no set formula for identifying which commodities a currency will be connected with and how strong the association will be. Some currencies, on the other hand, are good instances of commodity-forex connections.
Consider the fact that the price of oil is positively correlated with the Canadian currency. As a result, the Canadian dollar tends to appreciate against other major currencies as oil prices rise.
This is because Canada is a net oil exporter; when oil prices are high, Canada’s oil exports generate more revenue, boosting the Canadian dollar on the foreign exchange market.
The Australian dollar, which is strongly associated with gold, is another notable example. Because Australia is one of the world’s largest gold producers, its currency tends to fluctuate in lockstep with gold bullion prices. When gold prices climb sharply, the Australian dollar is projected to appreciate against other major currencies as well.
Keeping Rates Consistent
Some countries may choose to utilize a pegged exchange rate, which is set and maintained by the government artificially. This rate will not fluctuate throughout the day and will be reset on revaluation dates.
Emerging market governments frequently do this to keep the value of their currencies stable. To keep the pegged foreign exchange rate steady, the country’s government must maintain considerable reserves of the currency to which it is tied in order to limit supply and demand fluctuations.