Exchange rate is the link between the price of a given currency against another, which mean, the Exchange rate will tells us how many currencies of one determined currency are going to be needed to buy one single unit of the other currency. For example, to buy one Euro we need to pay 1.14 dollars.
Everytime there is a rate of change which is mainly determined by the supply and demand of each individual currency, that is, in the currency market. However, as we will see below, in some exchange rates systems central banks intervene the market to settle an exchange rate which is focus to boost its economy.
A currency converter is used to calculate the price or value of one currency with respect in another one. The currency market where the exchange rate is negotiated is called financial market or must commonly known as FOREX (Foreign Exchange) which by far is one of the most popular among currency investors.
Classification of exchange rate
Exchange rates can be found fixed or the type called floating exchange rates, normally depending on whether or not the central bank intervenes to set its rate.
Fixed exchange rate
The President of a country establishes the rate of its national circulating currency by associating the rate with one currency of another country.
Inside the fixed exchange rate are several exchange rates regimes depending and related extrictly on the performance of the central bank of each country. Regimes are as follow, These ones are ordered from the most strict to the most flexible:
Fixed exchange rates within which are several exchange rates rules depending on the performance of the central bank. The regimes are the following, ordered from the most strict to the most flexible:
Convertibility regime or currency board:
This one is the most strict category when it comes about fixed exchange rates, the exchange rates are set by law issuing. Its rules work the same way as gold, the central bank is forced to immediately exchange the currency linked whenever any citizen present. To do this, the person must have 100% of the money supply backed on dollars saved in their saving account.
Conventional fixed-rate regime:
A country fixes its currency using margins +/- 1% on another currency or different of currencies. This one can use direct intervention policies (buy or sell ), or indirect intervention policies (lower or raise the interest rates for instance).
Exchange rate within horizontal bands:
The fluctuations allowed to the currency are somewhat more flexible, around +/- 2%. It is also known as exchange rates with a target area.
Mobile exchange rate:
This exchange rate is periodically adjusted, usually because higher inflation with respect to the paired currency. It can be achieved passively or actively, issued in advance and applying the announced adjustments.
Type of change with mobile bands:
Similar to the exchange rate with horizontal bands, but the width of the bands is increasing little by little. It is usually implemented as an intermediate step to a floating exchange rate.
Floating exchange rate
Floating exchange rates are determined by the supply and demand of currencies in the market. There are two types of floating exchange, one completely free of intervention and another one somewhat intervened:
It represents a situation in which the currencies which exchange rate is that is obtained from the trading of supply and demand, without any central bank intervening at any time. It is also known as an independent flotation type.
In this situation currencies exchange rates are obtained from the trade of supply and demand, but in this case a central bank is forced to intervene by buying or selling the currency to stabilize or try to normalize the currency and achieve economic objectives. It is also known as a managed floating exchange rate, since it has a managed float, but is not announced previously.
The exchange rate in the foreign exchange market
Lets use an example to make it easier to understand. Take as a reference the exchange rate between the euro and the dollar (EUR / USD) . Always the currency of the left is the base currency (in this case the Euro), while the quote currency is the opposite (the dollar in our example).
Suppose that the exchange rate between these currencies is:
EUR / USD = 1.0827