What is the exchange rate?
An exchange rate (also known as a foreign exchange rate) is defined as the rate at which one currency can be traded for another. A rate can be quoted as spot rates, which is the current exchange rate, or forward rates, which are a price quoted today for delivery at a future date.
Rates are quoted in units of the base currency, such that one dollar could equal 0.6724 euros or 0.5992 pounds. Prices are usually quoted as a “buy” price at which the offerer is willing to purchase the base currency and a “sell” price at which the offerer is willing to sell the currency.
Traders make money on the difference between the buy and sell price. Exchange rates displayed online or in financial pages are averages of recently-completed trades and are not accurate enough for trading. Banks, multi-national firms, funds with large foreign holdings, and investors can use forex trading to “hedge” their investments against currency fluctuations.
Differences between Pegged and Free Exchange Rates
A pegged exchanged rate, also known as a fixed rate, is a system in which a currency’s exchange rate is matched to the value of another currency, the basket of currencies, or another valued substance like gold. Pegged rates are rare, and are typically only used by small countries with economies dependent on foreign trade. The benefit of this system is that rates are artificially stable between trading partners.
A free rate, also known as floating rates, is a system in which a currency’s value is allowed to freely float on international markets. It is the most common system found today. Central banks can manage free rates by buying and selling large quantities of the underlying currency, thus raising and lowering the market price. The third type of regime is the fixed float system, where central banks allow a currency’s rate to float between two fixed points.
Bilateral vs. effective exchange rates
Bilateral rates are simply the rate of exchange between two currencies such as the British pound GBP to USD converter. Effective rates, also known as a trade-weighted index, is a method of comparing the rate of one’s home currency against the currencies of its major trading partners to determine the economic impact of changes in currency rates. The currency of trading partners making up a higher percentage of foreign trade is given higher value in the index.
For example, the US dollar would be given a higher index value in a British pound-denominated trade-weighted index than the Mexican peso since the United States is a major trading partner of the United Kingdom. The effective rate is used to give economists a more complete picture of the relationship between one’s home currency and other currencies than is possible by simply comparing the rate between two currencies.