Types Of Currency Exchange Rates

There are some main types of currency exchange rates that you should familiarize yourself with if you plan on trading foreign currency. These include fixed exchange rate (also known as pegged exchange rate), floating exchange rate and linked exchange rate.

Fixed Exchange Rate

A fixed exchange rate is a kind of exchange rate regime where a foreign currency’s relative value is matched up to the value of another nation’s currency or to a grouping of other currencies, or to another measure of value like gold. As the value being used as a reference rises or falls, so too does the currency that is pegged to it. The opposite of a fixed currency rate is a floating currency exchange rate.

Floating Exchange Rate

A floating or flexible exchange rate is a kind of exchange rate regime

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where a currency’s rate is allowed to shift according to the foreign exchange market in general. Currencies that work this way are called floating currencies.

Pros and Cons of Fixed and Floating Exchange Rate Regimes

Basically, the largest advantage of floating exchange rate regimes is that those currencies values fluctuate according to the entire foreign exchange market, which means they are going to be able to ride out some smaller shocks of either their own economy or those of foreign business cycles.

On the other hand, fixed exchange rate regimes offer greater certainty and stability. When a currency’s value is related to a smaller group of currencies or just one currency, it is easier to foresee various economic factors and make reliable projections based on these factors.

A linked exchange rate is a kind of exchange rate regime that links the exchange rate of one currency to the exchange rate of another currency. Unlike a pegged exchange rate regime, the central bank or the government does not actively interfere with the foreign exchange market with supply and demand control of a currency. Instead, the exchange rate is stabilized by a mechanism.

Linked exchange mechanisms help return a currency to its baseline rate, by adding in additional feedback loops. For example, the central bank of a given currency may guarantee conversion at a particular rate. If the currency falls above or below that rate, then the demand or supply in the currency’s home market will drive the exchange rate back to its natural value.