Currency Exchange Rate | How Is It Fixed And What Affects It?

As you travel, study, live, and do business abroad more often, you frequently require to deal in various currencies such as dollars, euros, yen, pounds, and other curries apart from the Indian rupee. Every time you deal in two different currencies, you do a currency exchange. The rate at which you buy or sell currencies impacts your purse.

The currency exchange rate is also important to cross-border investors. When you are travelling abroad, evaluating the demand for your currency beforehand can help you save a precious amount of money. The reason is that you can choose the right platform based on the currency exchange rates it offers. Whether your transactions across currencies are big or small, awareness of currency exchange rates will help you save some additional money.

Here are a few key things to know about currency exchange rates:

How is the Currency Exchange Rate Fixed?

The exchange rate is determined by the supply and demand of a currency. If the supply of a currency is lower than the demand, the exchange rate of the currency will rise. For example, if you buy US dollars in India, you may have to pay extra because the buyers of the currency are more than the sellers. Most currency exchange rates are fixed by demand and supply. These currencies are referred to as floating. In some countries, the currency exchange rate is fixed by the government and is not determined by demand and supply. For example, the Qatari riyal has a fixed currency exchange rate of US $3.64 per riyal. Most currencies, including India, have a floating exchange rate. It is the reason we read about changing the value of the rupee against the dollar.

What Affects the Exchange Rate?

The exchange rate is affected by the economy, import and export, and financial regulations. For example, the value of Venezuelan currency crashed as they had an economic crisis.  India has a steady currency because it also has a steady economy. The US is at the centre of the world economy, and its currency is always in demand. The rise in exports causes an increase in demand for the local currency and pushes up the value of the currency. Overall, we can say that the factors that affect the economy also affect the exchange rate. A booming economy results in more currency transactions, and that increases the exchange rate. Governments can temporarily reduce the value of the currency to stimulate exporters as they get more value in local currency for their products/services.

What Are the Differences Between the Floating Exchange Rate and the Fixed/ Pegged Exchange Rate?

The exchange rate is said to be fixed if the value is determined based on some particular currency, such as US dollars or euros. In the case of a fixed rate, the government provides the exchange rate and buys or sells currencies to maintain this fixed rate. The Qatari riyal is one of the currencies which has a fixed exchange rate of US $ 3.64 per riyal. Bahraini dinar is fixed at 0.376 per dollar.

Most currencies work with floating rates. Floating rates for a currency are purely based on the demand and supply of the currency in the market. In a floating rate, the exchange rate is determined by the behaviour of the markets.  The Indian rupee is a floating currency, and it changes slightly in value every day.

Which is Better: a Fixed or Floating Exchange Rate?

Both fixed and floating exchange rates have their relevance. In some situations, a fixed exchange rate is better because it allows for predictability among the parties. One of the reasons some countries have a fixed exchange rate is that they want to provide stability to foreign investors.  For example, Qatar and Bahrain have maintained a fixed rate which provides investors safety from possible political and economic instability.

A floating exchange rate is relevant when the economy is steady, and the market is efficient. A floating gives a message to the world that the government does not interfere and wants to offer a free market economy.  Most major economies have a floating exchange rate. When making personal transactions, a floating exchange rate can be beneficial as a change in rates can go in your favour. For example, if you do a freelance assignment for a fixed amount in dollars, a fall in the value of the rupee will result in more money for you when the money hits your bank account. The floating exchange rate can cause a loss if the value of the rupee appreciates in the meanwhile.

What are the Advantages and Disadvantages of Floating Exchange Rates and Fixed Exchange Rates?

Both floating and fixed are relevant exchanges because they have their respective advantages and disadvantages:

Advantages of fixed exchange rate:

• Fixed exchange rates provide stability. For example, some countries in the Middle East and Africa have a fixed exchange rate system. So, your money as an investor is safer from major political or economic events.
• Currency fluctuations can be avoided by fixed exchange rates. Some countries have seen their currencies collapse during economic problems. This could have been prevented by using a fixed exchange rate system.
• Inflation and rise in prices can be avoided by using a fixed rate.
• Fixed exchange rates can make a place more attractive to do business. For example, if you are serving customers in a politically unstable country, your risk becomes lower if the currency in which your customers pay you does not change during the project.

Disadvantages of fixed exchange rates:

• A fixed exchange rate gives the message that the government interferes in business and can discourage entrepreneurs who seek a free market.
• Having a fixed exchange rate cannot fix economic problems in the long run.
• Fixed exchange rate rules out the option of increasing exports by letting currency reduce in value slightly.

Advantages of floating exchange rates:

• Major economies of the world use floating exchange rates
• It does not lay a burden of buying and selling currency on the government
• It gives more incentives to investors who specialize in currency trading
• It does not require the supervision of regulators
• An economy driven by floating exchange rates is seen as being market-friendly

Disadvantages of floating exchange rates:

• There are higher currency fluctuations to be managed. For example, when you want to send and receive money abroad, you have to be careful with changes in currency rates.
• Some investors who are not positive about the economic outlook of a country may not want to deal in its currency.
• Regulators cannot help much if the currency is fluctuating too much due to rumours or speculative activities

What is the Locked-in Exchange Rate?

When you send money abroad, the recipient will get the money after it is converted into their currency. For example, if you are sending a lakh rupees to your friend abroad, it will be converted to equivalent US dollars and given to him. There is normally a time lag between the time you send it and when it is received.  If the rate is kept flexible, then in this time lag, the value of your exchange rate can change if it is a floating currency. You can prevent this and keep the exchange rate fixed by locking it.  For example, you can ask the platform through which you are sending the money to choose the exchange rate from rupees to dollars that is prevailing at the time you send money from your account.

A locked-in exchange rate is one in which the currency rate is pre-decided at the time you are sending the money. Those who make big transactions must remember to decide as most currencies are floating, and change in the exchange rate is common during the transaction period.

FAQs

Is the Indian rupee a fixed or floating currency?

RBI has clarified that the Indian rupee is a free-floating currency, which simply means that its value is determined by the demand and supply, i.e., free market. However, there are occasions when the RBI intervenes to reduce the frequent change in value. But these interventions are exceptional, and the rupee is essentially a floating currency, like most currencies in most economies.

Is the U.S. dollar a fixed or floating exchange rate?

The US dollar is a floating currency. The value of the dollar is decided by the market. In the past, it was a fixed currency whose value was linked to gold.

Is it cheaper to exchange money in our own country or abroad?

For most currencies, it is cheaper to exchange money when you are abroad. This is because when you are abroad, the currency you are buying is abundantly available, while the currency you are paying is much less in supply. This makes it cheaper to exchange money abroad. However, people from countries whose currencies are not in demand should evaluate their options closely.

Should I exchange money before or after reaching a foreign country?

Travellers exchange some money in their own country as well as abroad. When you are going abroad, you are bringing in a currency that is lower in supply, so those exchanges that want your currency will offer you a better rate. Once you are abroad, the currency you are buying is easy to supply, so its rates are lower. However, please check if your currency is in demand in the country you are visiting.

Conclusion

The currency exchange rate is a subject that you can learn more about, and that will aid you in making better investments. While undertaking remittances, being savvy with currency exchange rates will help you save some money. One thing to learn about is floating and fixed exchange rates. There are many variables at play when working on forex exchange rates. When investing in currencies, studying historical exchange rates is a must. If you are travelling abroad, you can check how much your currency is in demand there and make wise decisions about converting money. All in all, it can be said that in a globalised world, it is financially prudent to learn more about currency exchange rates.