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Knowledge Crunch

What is Actually an Exchange Rate?

Tuesday, October 20, 2015 4:00 AM GMT

Exchange rates are what move the markets and international trading around. Commonly referred to as Forex, FX, forex rate, or foreign-exchange rate - at the end it breaks down to one thing only – how one domestic currency prices against a foreign one! 

The exchange rate between two currencies is determined in two ways – i) by the market itself or ii) by the government. When the market sets the price connection between two currencies, for example, the euro and the U.S. dollar, we are observing demand and supply factors driving the price of each currency towards the needed relevant direction.  It is not much different than the logic behind any market, where the price of apples, for example, is determined by the demand and its supply for apples. This type of exchange is called a floating exchange rate, where the level between two currencies is set by the market forces they participate in. Usually most of the developed countries have floating exchange rates.

The other common exchange rate is called a pegged regime. This is when a government intervenes to set a country’s currency exchange rate to a level of trading restrictions on the foreign exchange markets. Pegged regimes vary from country to country and governments have specific reasons to keep their domestic currency within a certain level. Usually this regime has some trade-offs,  meaning even though the domestic currency may be stabilized; there are chances of letting the country with little foreign portfolio investment. 

Disclaimer: This blog content is written for educational purposes and does not contain any investment advice.

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