Forex Exchange Rate - How Does It Get Calculated?

In the Forex market the value of two separate currencies and how they relate to one another is what is known as the Forex exchange rate. Usually the Forex rate is how much of one currency is needed to buy a unit of another. Knowing the basics regarding the Forex exchange can help you get started in understanding it even better.

Just to give you an example of how the Foreign exchange rate can work and to help you better understands it we can compare the United States dollar with the Japanese yen. Let's say that on a certain day the US dollar is able to buy one hundred and ten Japanese yens, this would indicate that the exchange rate for that day is 1:110 or a one to one hundred and ten ratio. This ratio in the exchange rate is also known as pairing. When you take it vice versa you can use it to indicate how many US dollars a single unit of Japanese yen can buy. Another term that is used in the Foreign exchange rate is 'cross rates'. This term however is only used when it does not involve US dollars; it is only used when relating two foreign currencies.

A few other terms used in the Forex exchange are pips or basis points, which are actually two terms used for the same thing. These terms are used to indicate Forex rates that are calculated up to four decimal points and whether or not these are negative or positive movements. An example of this would be if you were to exchange euros with yen at a value of 135.1030, but then the euro rate goes up to 135.1035, it is called a five-pip improvement.

In using the Forex exchange rate you are required to use two currencies and this means they are quoted as 'two tier' rates. Also in the Forex market its price basis is called a bid/ask. Using the previous ratio between the yen and the US dollar in the Forex market, if this trade is made it is called a ten pip 'spread' and is secured. This term means it indicates the difference between the buying and actual selling price. A lot of things can change the spread and affect it. These things include market conditions and traders' instincts about the strength of certain currencies, which can fluctuate greatly from day to day. One thing you should remember however when it comes to the Forex is that only Forex traders who are licensed can access official quoted rates. This means therefore that smaller investors may not receive their currency at a very good rate, because they usually receive them from commercial banks.

One last thing concerning the Forex exchange rate is that it is independently determined. This is why it thrives so well, because solely buyers and sellers and their supply and demand of certain currencies determine it. In the end individual governments and banks cannot decide the values.

With the benefits and knowledge of how the Forex exchange works you can decide if entering the Forex market is the right move for you. But with all the advantages of Forex, why wouldn't you want to?

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Fixed Vs Floating Foreign Exchange Rates

Open economies in a global market are confronted with three objectives - stabilising the exchange rate, enjoying international capital mobility and engaging in a monetary policy tailored for domestic goals.

Unfortunately, desirable as these are, they are contradictory. Fixed forex rates stabilise the rate while engaging in domestically-oriented monetary policy, these don't coincide with enjoying international capital mobility, which is where floating forex rates come in.

Fixed forex rates

A fixed foreign exchange rate is when a currency's value is pegged to the value of another currency, group of currencies, or another asset, like gold. Fixed rates were used globally from 1944 to 1973, but now fixed rates are mainly used by small countries with economies that are largely dependent on foreign partners.

Fixed exchange rates are infrequently evaluated for political and economic reasons, either being revaluated or devaluated. A devaluation in a fixed rate lowers the value of the fixed currency, making exports more attractive to foreign investors as they become cheaper when their value is converted into the investors' currencies. This also discourages imports as imported goods become more expensive due to the forex rate, the ultimate goal being to increase trade surpluses while decreasing trade deficits.

A revaluation raises the value of the fixed currency, causing the opposite scenario to occur.

Floating forex rates

Floating foreign exchange rates are when a currency's value changes depending on factors in the forex market, such as the currency's economy, investor sentiment, politics, inflation and interest rate derivatives.

This is the most common regime for major economies with two variants: free floating currencies and managed floating currencies.

The value of free floating currencies is solely determined by forex market forces and can fluctuate greatly, providing opportunities for traders to profit on rising and falling currency values.

Managed floating currencies are allowed to float to a certain extent, and will be reined in by the central bank if it travels too far from ideal levels.

That being said, every floating rate is managed, at least slightly. If a currency goes too far off course, that country's central bank will respond by changing interest rates or by buying and selling large amounts of currency to bring its currency back to acceptable levels.

Fixed vs. Floating forex rates

Fixed exchange rates benefit from reduced risks in international trade and investment as international buyers and sellers can agree to a price that won't be vulnerable to forex rate changes. Fixed rates can introduce stricter economic management, keeping inflation under control, and they can also reduce speculation, which can be destabilising to less-established economies.

However, the disadvantages of fixed rates are that there is no automatic balance of payments between nations without government interference; large holdings of foreign exchange reserves are necessary to maintain the fixed rate; the need to maintain the exchange rate can dominate monetary policy, which may be better focused on other things; and fixed exchange rates can be unstable, resulting in different rates of inflation causing imbalances of the levels of competitiveness between different countries.

Countries with floating exchange rates benefit from allowing the market to quickly respond to economic events, as opposed to waiting for the central bank's reaction. As the forex market is open 24-hours a day, free floating currencies can react very quickly to significant news. This also results in automatic correction in balance of payments adjustments as the exchange rates adjust to balance supply and demand.

As this will be taken care of automatically, governments should have more time to devote policy to other matters.

As floating rates change automatically, they don't suffer from international relations crises that can plague countries with fixed foreign exchange rates when pressure mounts on a currency to devalue or revalue.

And countries with floating exchange rates can have lower foreign exchange reserves.

However, floating exchange rates result in instability and uncertainty when it comes to international trade, as fluctuations can result in changing prices for imports and exports. This uncertainty can also lead to a lack of foreign investment. Having said that, this risk can be hedged by trading with forward transactions.

Floating exchange rates can result in undisciplined economic management as inflation is not punished, and governments may follow inflationary economic policies.

However, the downside of this is that severe shocks can cause a currency to plummet, magnifying the economic damage. And, as speculation is higher in floating exchange rate regimes, there is more uncertainty for forex traders and investors. A floating exchange rate can also cause inflation by allowing import prices to rise as the exchange rate falls.

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