Reviewed by Gordon Scott
International currency exchange rates define how much one currency can be exchanged for another. Knowing the value of a home currency to different foreign currencies helps investors analyze assets priced in foreign dollars.
Currency exchange rates can be floating, in which case they change continually or they can be pegged to another currency, in which case they still float, but move in tandem with the currency to which they are pegged.
Key Takeaways
- Fixed exchange rates are set to a pre-established peg with another currency or basket of currencies.
- A floating exchange rate is determined by supply and demand on the open market.
- Floating exchange rates became popular after the gold standard ended and the Bretton Woods agreement was implemented.
Types of Exchange Rates
Currency prices can be determined by a floating or a fixed rate. A floating rate depends on the open market through supply and demand. Therefore, if the demand for the currency is high, the value will increase. If demand is low, this will drive that currency price lower.
The currencies of most of the world’s major economies were allowed to float freely following the collapse of the Bretton Woods system between 1968 and 1973. Therefore, most exchange rates are not set but are determined by ongoing trading activity in the world’s currency markets.
A currency peg is a policy in which a national government or central bank sets a fixed exchange rate for its currency with a foreign currency or a basket of currencies. This action attempts to stabilize the exchange rate between countries.
See Investopedia’s picks for Best Forex Brokers.
Factors That Influence Rates
- Floating rates: Rates are determined by market forces and supply and demand. Countless geopolitical and economic announcements affect exchange rates between two countries including interest rate changes, unemployment rates, inflation reports, gross domestic product numbers, manufacturing data, and commodities.
- Fixed or Pegged Rate: A central bank or government determines the rate. The rate is set against another major world currency such as the U.S. dollar, euro, or yen. To maintain its exchange rate, the government buys or sells its currency against the currency it is pegged to.
- Macro Factors: The “Law of One Price” dictates that in a world of international trade, the price of a good in one country should equal the price in another. This is called purchasing price parity (PPP). If prices are volatile, the interest rates in a country will shift—or the exchange rate will change between currencies.
- Forex and Commodities: The more dependent a country is on a primary domestic industry, the stronger the correlation between the national currency and commodity prices. Some currencies provide good examples of commodity-forex relationships. The Canadian dollar is positively correlated to oil. As the price of oil increases, the Canadian dollar tends to appreciate against other major currencies. This is because Canada is a net oil exporter; when oil prices are high, Canada tends to reap greater revenues from its oil exports giving the Canadian dollar a boost on the foreign exchange market.
Note
As of 2023, the most valuable currency in the world is the Kuwaiti Dinar (KWD).
Maintaining Rates
Some countries may use a pegged exchange rate set and maintained artificially by the government. This rate will not fluctuate intraday and may be reset on particular dates known as revaluation dates. Governments of emerging market countries often do this to create stability in the value of their currencies. To keep the pegged foreign exchange rate stable, the government must hold large reserves of the currency to which its currency is pegged to control changes in supply and demand.
Extreme short-term moves can result in intervention by central banks, even in a floating rate environment. Because of this, while most major global currencies are considered floating, central banks and governments may step in if a nation’s currency becomes too high or too low.
A currency that is too high or too low could affect the nation’s economy, affecting trade and the ability to pay debts. The government or central bank will attempt to implement measures to move their currency to a more favorable price.
Where Are Foreign Exchange Rates Published?
Foreign exchange rates are available online. These sites display the numerical relationships between each currency. Many offer currency converters, showing how much a certain currency equals another currency. A popular foreign exchange rate site is XE.com.
What Are Exchange Rates Based on?
Exchange rates for floating currencies are based on the supply and demand of one currency versus another. The exchange rates between two currencies shift as the supply and demand for each change. For fixed currencies, the exchange rate is based on a peg to another currency and changes with the value of the other currency.
What Affects Foreign Exchange Rates?
Foreign exchange rates are affected by a country’s political climate, inflation, public debt, GDP, confidence, government intervention, and trade.
The Bottom Line
Currency prices are determined in two ways: fixed rates and floating rates. Fixed rates are pegged to a currency while floating rates move freely with market demand. Nations attempt to manipulate their currencies to remain strong and demand for their currency is high in foreign exchange markets.