If you are busy trading the currency markets for a while, the chances are that you are used to the fluctuations in the rate between two currencies.
Usually, these exchange rate fluctuations happen due to the open markets. An exchange rate or a foreign exchange rate is the rate at which you can convert one currency for another.
When the exchange rates are freely floating and depending on the popularity or demand for the currency in questions, the exchange rates can vary.
While this might seem the norm, there are many other types of exchange rates that you haven’t come across. A country can set its exchange rate to be a free or a fixed exchange rate. This purely depends on economic reasons. A freely floating exchange rate can switch to a fixed exchange rate and vice versa.
In this article, we take a look at the three main types of exchange rates and how they differ.
In the forex markets, the exchange rate is the rate you pay to convert one currency to another. Therefore, if you see an exchange rate of EURUSD of 1.1400, this means that 1 euro is equal to $1.14.
Among the exchange rate types, there are different kinds too. For example, the spot exchange rate is the rate that you will receive on the spot. A forward exchange rate represents a rate which is agreed upon for a future date of payment or delivery of the currency.
In retail trading, the spot markets are commonly used. However, there is no physical delivery of the other currency.
Another important aspect to bear in mind is the convention. When an exchange rate is quoted as EURUSD, the first currency is called the base currency and the second currency is called the quote currency. As the terms suggest, the base currency is the currency that you want to exchange.
The exchange rate represents the rate quoted in the quote currency.
Types of exchange rates
Exchange rates fall into three main types.
- Floating exchange rate
- Fixed exchange rate
- Pegged exchange rate
Let’s take a look at each of these exchange rate types in detail.
Floating exchange rate explained
A floating exchange rate, as the name suggests allows the currency or two currencies to free fluctuate. Under the floating exchange rate regime, the exchange rates can vary. The fluctuations in the exchange rate happen due to market forces.
The open markets determine the exchange rate for the currencies. Some of the most widely used currencies such as the euro, the U.S. dollar, the Canadian dollar, the Japanese yen, the British pound sterling among others operate under a floating exchange rate regime.
These are also one of the most liquid currencies that you can find. This is due to their popularity and demand in general.
The major currencies broke into a floating exchange rate regime after the U.S. dollar broke away from the fixed peg to an ounce of gold. Some of the other popular floating exchange rates include the Indian Rupee, Brazilian Real and the Russian ruble.
With a floating exchange rate, the currencies can be susceptible to market pressure. Central banks, from time to time defend the exchange rates to prevent them from appreciating or depreciating too much.
An excellent example of this is the Japanese yen. Around 2015, when the nation experienced a heavy earthquake and the resulting nuclear crisis, the Bank of Japan intervened to sell the yen.
This was done as the yen is considered a safe haven currency and the crisis led to the yen strengthening sharply. Given that Japan is a country that relies on exports, the higher exchange rates was not preferable. As a result, the Bank of Japan sold almost 14.3 trillion yen to stabilize the exchange rate.
Fixed exchange rate
A fixed exchange rate is where the rate of one currency is pegged to the other currency. Sometimes, a fixed exchange rate refers to a pegged exchange rate. But this is incorrect as a pegged exchange, which looks almost similar to a fixed exchange rate is somewhat different.
In the earlier days, before the switch to the floating exchange rate, the U.S. dollar was pegged to the price of gold. This was prior to the Bretton Woods agreement. One U.S. dollar was pegged to the value of gold at $35. This was the reference point.
Many foreign currencies, in turn, were fixed to the U.S. dollar.
With a fixed exchange rate, there is a lot of pressure on the central bank. While in a freely floating exchange rate, market forces set the rates, in a fixed exchange rate the central bank manages the supply and demand of the currency.
This would involve the central banks having to buy and sell the currency to manage the fixed exchange rate.
Some recent examples of a currency breaking out from a fixed exchange rate to a floating exchange rate is the Russian ruble. Around late 2014, the ruble broke out from the fixed exchange rate regime amid falling oil prices. This required the central bank to defend the peg by buying rubles and selling U.S. dollars.
Eventually, when the central bank of Russia failed to defend the currency, the Ruble became a free-floating exchange rate.
A fixed exchange rate comes to play when an economy wants to maintain low inflation and facilitate trade and investment. This helps to keep the interest rates low in the longer term.
Typically, developing or smaller economies prefer to use a fixed exchange rate system.
Pegged exchange rate
A pegged exchange is similar to a fixed exchange rate. The difference here is that one of the currencies can deviate from the other within a certain range. For example, the Chinese Yuan is pegged to the U.S. dollar.
One U.S. dollar was pegged to 8.28 yuan. The peg was in place since 1994. Since 2005, the yuan can deviate within a range of 2.1% from the fixed rate of 8.28 yuan to the dollar. Over the years, the yuan can supposedly devalue its currency one time. Central bank officials continuously look at the pegged exchange rates at regular intervals and can move this peg around.
Besides the U.S. dollar, the yuan is also set to a managed float with some other currencies.
With a pegged exchange rate, the central bank publishes what is known as the daily reference rate. The daily reference rate allows the currency to fluctuate within a fixed band.
The central bank maintains the band by buying and selling the yuan and also the U.S. dollars.
Another example of a pegged exchange rate was the euro and the Swiss franc. The EURCHF peg came in 2011. The value of one euro was pegged to 1.2 Swiss francs. The currency peg introduced to stem the CHF to appreciate in value.
However, due to the EUR depreciating against the USD, the CHF also continued to erode in value. In January 2015, the Swiss franc peg was removed making it a floating exchange rate to a certain limit.
In conclusion, among the three types of exchange rates, the floating exchange rate is probably the best exchange rate type to trade when it comes for day trading or speculating. While trading pegged exchange rate offers some trading opportunities, they are inherently risky.