What you should know about foreign exchange rates
Foreign exchange rate can be defined as the price of the domestic currency I.e the currency of your country with respect to another currency.
The exchange rate affects finance-oriented institutions involved in currency trading such as banks.
It can also affect businesses because it changes the demand and supply from other countries.
The exchange rate for a specific currency is often referred to using an acronym. Some common ones that you might have come across include: GBP representing Pound sterling, USD representing the US dollar, EUR representing Euro and NGN representing the Nigerian Naira.
Usually, an individual will directly deal with the foreign exchange rate when traveling or sending money abroad.
In such a case one will definitely encounter what is referred to as the buying and selling rates.
The buying rate refers to the rate at which foreign currency is bought back in exchange for your currency.
The selling rate on the other hand refers to the rate at which you sell your currency in exchange for the currency of the country you’re traveling to.
For example; Mr A wants to travel from England to France and the exchange rate for the pair GBP/EUR is 1.20. If Mr A is converting £250 (pounds) to Euros, he would be getting €300 (euros). This is the selling rate.
If after his trip he has €66 left and wants to convert back to pounds but the exchange rate depreciates to 1.17 he would be getting back £56. This is the buying rate.
Factors that affect the exchange rate
The factors impacting the exchange rate could be of economic, political or psychological origin.
The economic factors that can cause variation in foreign exchange rates include Inflation, Supply and demand, the country’s debt and government policies.
Political factors include political instability, unrest or conflict and the psychological factor involves the psychological state of the people participating in foreign exchange.
Other factors include Gross domestic product, Market interest rates and Unemployment rates.
Types of exchange rate systems
There are systems that have great effect on the Foreign exchange rate. These systems are:
Fixed/pegged exchange rate system
The pegged exchange rate or the fixed exchange rate system simply refers to the system where the weaker or less valuable currency of the two currencies in question is pegged or tied to the stronger or more valuable currency.
Fixed exchange rate is determined by the country's government or central bank and is not dependent on the activities happening in the trading market.
There is purchasing of foreign exchange by the central bank or government of a country when the rate of foreign currency increases and selling foreign currency when the rates fall. This is done to maintain the stability of the currency.
This process is known as pegging hence the name Pegged exchange rate system.
Countries like Saudi Arabia and Denmark use this system where their currencies are pegged or tied to the US dollar.
The advantages of this system are stability in the value of the country's currency which protects it from market fluctuations. It promotes foreign investment for the country.
On the other hand, a disadvantage of this system is the constant need for maintaining foreign reserves in order to stabilize the economy.
Flexible/floating exchange rate system
Flexible exchange rate system is also known as the floating exchange rate system. It is completely dependent on the activities occurring in the market on supply and demand.
There is no intervention of the central banks or the government in the floating exchange rate system.
Countries that use this system include Canada, Mexico, Australia etc.
An advantage is there would be no need to maintain foreign reserves in this exchange system.
While some of the disadvantages include It encourages speculation that may lead to fluctuations in the exchange rate of currencies in the market.
If the fluctuations in exchange rates are too much it can lead to issues with movement of capital between countries and also impact foreign trade.
This will in turn discourage any type of international trade and foreign investment.
Managed floating exchange rate system
Managed floating exchange rate system is the combination of the fixed and floating exchange rate systems.
It is an exchange rate regime in which the exchange rate is neither entirely free (or floating) nor fixed.
Rather, the value of the currency is kept in a range against another currency (or against a basket of currencies) by central bank intervention.
This system offers flexibility and stability but can lead to manipulation and unpredictability.
Having sufficient knowledge on the Foreign exchange rate and the trading market is important.
These dynamics have a significant impact on businesses, our day to day purchases and cost of living.
This knowledge also helps in deciding on the best and most reliable ways to send money to friends and loved ones living abroad.
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