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Here are a few things to know about exchange rates

The exchange rate is the value at which a currency is converted into another. Today exchange rates are often used to engage in speculation or to do trading in the foreign exchange market. There are wide varieties of factors that influence the exchange rate such as inflation, interest rate, current account deficits, public debts, political stability, and economic performance in each country. An exchange rate is also known as the foreign exchange rate or forex rate. The FX rate between two countries is the value at which one currency is exchanged for another. It can also be described as the value of one country’s currency in terms of another currency. For example, an interbank exchange rate of 250 Yemeni Rial to the US dollar means that 250 Rial will be exchanged for 1 dollar or 1 dollar will be exchanged for 250 Rial.

The foreign exchange market determines today’s exchange rate, which is open to a mixed group of buyers and sellers where currency trading happens 24 hours a day except weekends. The current exchange rate refers to the spot exchange rate. The forward exchange rate refers to today’s exchange rate value quoted and traded today, but dealers will quote a different buying and selling rate for future payments. The maximum percentage of trade happens within the country. The buying rate is the rate at which the money dealer will buy foreign exchange, and the selling rate is the rate at which they sell the currency. The quoted rate will incorporate profit in his trading, or the profit will be recovered in the form of commission or any other way.

Methods of exchange
The major types of exchange rates are fixed exchange rate and floating exchange rate.

  • Floating exchange rate: In the floating system, the external value of the currency depends entirely on the market forces of supply and demand. There is no intervention in the currency markets from the central bank because the central bank allows the currency to find its level. Many countries like US, Canada, UK, Australia, and Poland still have a floating exchange rate. A good example to explain floating exchange rate is by comparing the value of Sterling against US dollar; Sterling fell and depreciated more than 20% in 2009, it opened a little bit of ground and fluctuated around one dollar 55 and one dollar 60 for several years.
  • Fixed exchange rate: A fixed exchange rate is otherwise called as the pegged exchange rate. It is a type of exchange rate regime where a currency’s value is fixed against either the value of another single currency to a basket of other currencies or another measure of value such as gold. Normally, there are both benefits and risks involved in using a fixed exchange rate. It is usually used to stabilize the value of the currency by directly fixing its value in a predetermined ratio to a different, more stable or more internationally prevalent currency or currencies to which the value is pegged. By doing so, the exchange rate between the currency and its pay does not change based on market conditions the way floating currencies do. This makes trade and investments between the two currency areas easier and secure. Fixed exchange rates are used for small economies in which external trade forms a large part of their GDP, as a means to control the behavior of currency by limiting rates of inflation.

Factors that influence today’s exchange rate

  • Inflation: If the UK is facing an inflation at the moment, which is relatively lower than any other country, UK exports will become competitive and there will be an increase in demand for Pound Sterling to buy UK goods. Also, foreign goods will turn less competitive leading the UK citizens to buy fewer imports.
  • Interest rates: A rise in interest rates guarantees higher returns for investors, increasing the demand for that currency and therefore its value. Exchange rates, inflation, and interest rates are always in agreement. The central banks control and manipulate the interest rates to influence both inflation and exchange rates, and the fluctuating interest rates affect inflation and currency values. Higher interest rates attract foreign capital causing a growth in today’s exchange rate.
  • Current account deficits: If the country spends more on foreign trade than its earning and then makes up the deficits by borrowing from other countries, the investors will back off with their investments and the value of the local currency will drop. A country requires more foreign currencies through trading, and it supplies them more locally. When the demand for foreign currencies shoots up, the country’s interest rates go down.
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