What is an Exchange Rate?

Let’s find out exactly what this expression “exchange rate” is, which we hear all the time, and also what the elements are which break this phrase up into digestible chunks…

What is an Exchange Rate?

What types of exchanges are there?

Before we dive into the minerals of the topic, let’s first acknowledge that exchange rates can be (rarely but on some brief occasions) fixed or fluctuating, this depends on the central bank and how they use their powers of intervention. Fun fact: did you know that there are groups of powerful and wealthy investors who band together through hedge funding and so forth, to change the direction of a currency? Clearly this is a tactic in order to change the direction at the best times to suit themselves, but let’s move on...

The exchange rate, or also referred to as the rate of exchange, is the ratio between the value of a currency - in a different currency. It is the price of a foreign currency unit indicative in terms of a national currency. Therefore, the exchange rate is an indicator that maintains an important relationship within international trade, mainly among countries that do not have the same currency.

It should be taken into account that on different occasions there is an exchange rate that is fixed by supply and demand, which is a core element of the foreign exchange market (you may have heard more about this through our other articles on LVMexchange). However, the central banks of each country also intervene in these moving markets, establishing an exchange rate that benefits them within their economy.

What if all you want is to calculate the value of one currency with respect to another? You simply need a currency converter; the different moving values are managed by powerful parties across the world. Although if you have any questions about where to trade with this market, Forex is the service you’re looking for with a broker such as LVMexchnage - recognized as one of the largest and most popular in the market, through word of mouth and trading education.

Fixed exchange rates: the government of each country establishes the value of the national currency by relating the value to that of the currency of another country which is at a given time, fixed – ie. not moving and not variable. Fixed exchange rates do indeed play a highly significant role in the foreign exchange market, since they contain volatility.

Now we know some of the fixed exchange rate factors, remember that elements which command the values most often than not depend on movements and decisions decided by the central bank. Since an exchange rate is established by elements surrounding financial law. To understand this a little better, national cash flows are defined by foreign assets, so in turn with this regime we can emphasise the fact that as production levels across different industries increase considerably, the unemployment rate decreases. Inflation balances subtly in these cases, and other topics such as the counties risk rate tend to also decrease. So you see, this is the larger scheme of things not just how much USD you can get for your GBP.

Without getting too technical, we do need to explain some slightly complicated elements, one of which being something you may have heard of as a conventional fixed rate. This is when a country sets its currency with margins of +/- percentage over another currency, for the purpose of persuading an assets direction. A prime example here is buying or selling the currency, which seems straight forward, simply larger bulk purchasing and selling which at the right timecarries a domino effect. Or... indirect intervention policies - such as lowering or raising the interest rates for example.

A term you may also come across is “mobile exchange rate” in essence the exchange rate is adjusted regularly, which is done in a way that it is parallel with a high inflation - in relation to the linked currency; this can be done passively or aggressively. Exchange rate with mobile bands are similar to the exchange rate with horizontal bands, but the width of the bands is gradually increasing, we’ll need to cover this in another session as the bands being flexible etc, this ventures into another topic. However this is an intermediate method to subsidisea floating exchange rate.

There are two types of floating exchanges.

  1. Clean or independent flotation: this happens within a situation in which the currencies are take into account that the flotation itself depends solely on supply and demand. The central bank does not intervene at any time, in this case making it quite singular, as the central banks often do play a hand.
  2. Dirty flotation or managed floating exchange rates: within this situation, the currencies exchange rate is obtained based strictly on the transactions between the purchase and sale of currencies usually via central banks. Which is what we knew before, although you may come across this expression.

The central bank once again intervenes directly buying or selling in large quantity, believe it or not - mostly with “the peoples” money, being you and me -but don’t worry it’s done in an intelligent way with a clear view to economic objectives.

We hope this article has helped to define what makes up the exchange rates... the power of central banks... and when you hear expressions such as “mobile” or“floating” exchanges. At LVMexchange we take pride in educating our traders before they invest funds, we’re always on standby to answer any questions so please do feel free to get in touch with a member of our team. And if you would like to learn more about forex trading, exchanges and strategies, look out for our next article.