Exchange Rates: Definition, How They Work, Why They Fluctuate
Let’s try and understand the basics what exchange rates from the definition to how they work.
What Is An Exchange Rate?
In simple terms, an exchange rate is a rate at which one currency is exchanged with another currency. Exchange rates also determine and influence international trading between different countries. The exchange rates generally depend on the demand and supply of the currencies in different countries. To understand the concept of exchange rates in a simple manner, let’s look at an example. When economists or financial experts say that the rate of the Rupee (₹) is 80 to the Dollar ($), it essentially means that $1 dollar equals the ₹80 rupees. In the context of this example, if you were to go to the US for any reason, you would have to convert your Rupee into Dollars at the rate of ₹80 in exchange for $1, aside from the conversion fees, etc. At the time of writing this article, the Rupee rate stands at ₹82.86 for $1.
How Do Exchange Rates Work?
The exchange rates between two different currencies are determined by factors such as economic activity, GPD, import and export, market interest rates, etc. Commonly referred to as market exchange rates, they are set by the global financial markets as banks and other major financial institutions trade currencies constantly based on the above-given factors. Changes in exchange rates can happen multiple times in a day, but a consistent major change in exchange rates generally happens over a period of time. Exchange rates are often represented by the acronym for national currencies, such as INR/USD. Changes in affect rates also affect the levels of import and export between countries, since the purchasing power between currencies also changes. For instance, if the Rupee devalues from ₹80 to ₹90 for $1, then purchasing products, services and raw materials becomes more expensive for consumers and businesses in India. On the other hand, US buyers and businesses can get more value out of $1 for Indian purchases than before.
Fixed And Free-Floating Exchange Rates
Exchange rates can be either fixed or free-floating, but most exchange rates for currencies are of fluctuating type. As mentioned above, fluctuating exchange rates depend on a variety of factors and are determined through the foreign exchange market. On the other hand, a fixed exchange rate is pegged to the value of another currency. For instance, the Hong Kong Dollar is pegged to the US Dollar at the rate of 7.75 to 7.85, indicating that the value of the Hong Kong Dollar will remain within this range. Currency traders also have ‘spot rates’ and ‘forward’ rates for currencies. Spot rates refer to the current value of the currency, whereas the forward rate refers to the expected value of the currency in the future, on the basis of which currency trades are often made.
Understanding Forex?
As mentioned previously, the rates of different currencies fluctuate based on trades made by banks and financial institutions. These trades are carried out through the foreign exchange (Forex) market. The Forex is the biggest financial market in the world where banks, corporations, financial institutions, hedge funds, forex traders/brokers, and investors all interact. Trillions of dollars worth of trades are carried out through the Forex market every day. There are two levels in the Forex market; the interbank market and the over-the-counter (OTC) market. While Forex trading can bring in significant profits, the risk of an equally significant loss also remains. Forex traders try to earn profits by predicting whether the rates of a currency will fall or rise and then make the appropriate trades.
