Exchange Rates

An exchange rate is the amount of one currency that is needed to buy one unit of another currency. For example, the euro/US dollar exchange rate, also written as EURUSD, may be 1.38. This means that it takes 1.38 dollars to buy 1 euro.

For instance, you need to “buy” a foreign currency often when you go on holiday, or if a company wishes to purchase supplies from abroad, they often have to exchange their own currency for that of the supplier in order to in order to conclude payment.

The exchange rate comes directly into play to decide the quantity of the home currency that is necessary to meet the price of the supplier currency. Exchange rates are inherently volatile and prone to risk.

Types of exchange rate: (1) floating and (2) fixed

1. Floating exchange rates:
   • In stark contrast to fixed exchange rates, floating exchange rates are currency pairings whose price constantly changes.
   • They are used almost everywhere in the “developed” world. Floating exchange rates can change by the second, as a result of the constantly changing variable factors that influence a currency’s strength.
   • The strength of a currency is measured in its comparison to other currencies through exchange rates.
   • They fluctuate as currency value is determined by a series of supply and demand factors, including trade flows, tourism, interest rates, rates of inflation, political stability and speculation.
   • For instance, if interest rates are increased substantially, in the UK, demand for pound sterling will increase as people will invest money to the British currency to take advantage of the interest rate increase and make money. If interest rates fall, the opposite consequence is highly likely to occur.
   • Therefore, governments attempt to control various factors to ensure exchange rates are at a level that will help their respective economies grow. A delicate balance often has to be struck.
2. Fixed exchanged rates:
   • A fixed exchange rate is where a currency of one country is “pegged” to a stronger currency, whose purpose is to maintain the weaker currency’s value within a tight range, thereby protecting it significantly from the risk of fluctuation.
   • Fixed exchange rates protect the valuation of a weaker currency by providing less uncertainty regarding importing and exporting prices, and assisting a government in maintaining low interest rates and thus, low inflation rates. This is intended to lead to increased trade and economic stimulation.
   • Many African nations have pegged their currencies to the Euro for instance, while many Latin American countries are pegged to the U.S. dollar.
   • They are traditionally pegged to the currency of a larger trading partner.

Free-floating currencies are the most widely used in global commerce. Bearing in mind their volatile exchange rates, international companies need to put a solid currency management strategy in place to protect their profits from adverse market movements.