How are Currency Exchange Rates Determined?

When learning about international currency markets, there are two types of exchange rates you will encounter:

  1. Floating: rates fluctuate according to economic supply and demand.
  2. Fixed: rates for two currencies are tied together so that they move in relation to one another.

Floating rates change without consideration of any other currency. They are determined by various factors in the economic system backing them. So, if a country suddenly breaks out in civil war, you can predict a substantial change in economic stability. The threat or actuality of instability may lead to changes in the value of that currency, leading to volatility in the Forex market.

Exchange Rate DeterminationFixed rates still react to changes in economic systems, but they also take the value of another currency into consideration. Rather than moving independent of one another, the currency pair moves together based on various factors affecting the economic systems backing both currencies.

The decision to fix or peg a currency is made by governments. These governments set the exchange rate, and they can change it whenever they see fit. You will find that fixed rates don't fluctuate throughout the course of a typical trading day, so they are more predictable. Some governments may change their rates on set dates while others are more sporadic. The goal for the government is always to create more stability for their currency.

The Value of Currency

Exchange rates tell you the value of one currency when compared to another. Every Forex trader must have a strong understanding of their country's currency value when compared to various other currencies from around the world. This is the foundation of determining which positions to take in the market. Once you understand your currency's value in comparison to others, you can follow the charts and economic or political changes in different areas of the world to make predictions and buy positions.

Value is all about supply and demand. When there is great demand for U.S. dollars but the euro isn't in such high demand, then the U.S. dollar will have a higher value than the euro. That comparison is taken into consideration when you want to exchange one of these currencies for the other.

Supply and demand for any currency can change at any moment. That is what makes the Forex market so unpredictable, and many traders find that exciting. Others find it risky but hang in there because they want to make money.

Factors that Can Influence Exchange Rates

The exact science of determining exchange rates is complicated and highly technical. What you need to know as a trader is the variety of factors that can have an impact on changing rates for any currency. This list will give you the most common factors:

Factors that influence exchange rates

Anything that affects the economic system of a country can have an impact on the value of that country's currency. The change in currency value leads to changes in the exchange rate, especially for currencies with floating exchange rates.

This is why successful Forex traders watch for reports and updates released from various countries on a routine basis. They will also pay more attention to international news broadcasts than people uninterested in Forex trading. Traders are always looking for signs that a currency's value is going to rise or fall in relation to other currencies. When they make accurate predictions, they can buy or sell positions that give them profitable advantages in the Forex market.

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