Fixed and Floating Exchange Rate Systems

 
 
 
There are many different areas of the financial system that might not affect your day-to-day activities as a trader, but they might still hold an interest or enhance your overall knowledge base – which is never a bad thing.

 

 

One is understanding the difference between fixed and floating exchange systems. As a trader, you might think that you will trade almost exclusively in floating exchanges, which are essentially those allowed to fluctuate in response to the Forex market itself. Fixed exchanges are those that are pegged to another currency, collection of currencies or other measures of value such as gold. These do not lend themselves so easily to trading for obvious reasons, but in reality most exchange rates exist somewhere between the two extremes. There might not be official pegs on the majority of tradable currencies, but governments and central banks will often employ strategies designed to have an effect on currency values for a variety of different reasons.

Currencies do not have inherent values in and of themselves, and the relative value of any given currency is typically expressed in terms of how much of another reference currency it is currently worth.

In fixed exchange rate systems, the currency’s value is fixed or pegged against the value of another asset, which is generally another single currency such as the US dollar. This fixing is done by the relevant government or monetary authority rather than being left to the market, and the country’s central bank stands ready to buy or sell its currency at a fixed price. The value of a pegged currency can fluctuate against other currencies as widely as the one it is pegged against. If the USD falls against the EUR, for example, so will a currency pegged to the USD. Very little deviation is allowed when it comes to the relative value of the currency against the one it is pegged against.
Pegging is relatively uncommon these days, but historically the majority of countries and economies used a gold mark system that was essentially the same. Instead of pegging their currencies to other currencies however, they were instead linked to the price of gold. The gold standard system was abandoned around the time of WWI. Following WWII, the Bretton Woods system replaced gold with the US dollar as the global reserve asset.
A fixed exchange rate system can help ensure stability, which in turn can encourage foreign trade. It can prevent capital outflow and minimise risk and uncertainty in international trades, but there is a major risk of devaluation. This can occur when reserves are exhausted but demand remains, compelling a government to devalue its own domestic currency.
A floating or flexible exchange rate system is allowed to fluctuate with the market, with no official intervention. This allows deficits and surpluses in a country’s balance of payment to automatically correct, negates the need for a country to hold its own foreign exchange reserves and, of course, presents Forex traders with the opportunity to speculate on the constant market-driven fluctuations.