An exchange can operate under one of four main types of exchange rate
systems:
Fully fixed exchange rates
In a fixed exchange rate system, the government (or the central bank acting
on its behalf) intervenes in the currency market in order to keep the exchange
rate close to a fixed target. It is committed to a single fixed exchange rate
and does not allow major fluctuations from this central rate.
Semi-fixed exchange rates
Currency can move within a permitted range, but the exchange rate is the
dominant target of economic policy-making. Interest rates are set to meet
the target exchange rate.
Free floating
The value of the currency is determined solely by supply and demand in the
foreign exchange market. Consequently, trade flows and capital flows are the
main factors affecting the exchange rate.
The definition of a floating exchange rate system is a monetary system in
which exchange rates are allowed to move due to market forces without
intervention by national governments. The Bank of England, for example,
does not actively intervene in the currency markets to achieve a desired
exchange rate level.
With floating exchange rates, changes in market supply and demand cause a
currency to change in value. Pure free floating exchange rates are rare - most
governments at one time or another seek to “manage” the value of their
currency through changes in interest rates and other means of controls.
Managed floating exchange rates
Most governments engage in managed floating systems, if not part of a fixed
exchange rate system.
The advantages of fixed exchange rates
Fixed rates provide greater certainty for exporters and importers and, under
normal circumstances, there is less speculative activity - though this depends
on whether dealers in foreign exchange markets regard a given fixed
exchange rate as appropriate and credible.
The advantages of floating exchange rates
Fluctuations in the exchange rate can provide an automatic adjustment for
countries with a large balance of payments deficit. A second key advantage of
floating exchange rates is that it allows the government/monetary authority
flexibility in determining interest rates as they do not need to be used to
influence the exchange rate.
Who are the participants in today’s Forex market?
In general, there are two main groups in the Forex marketplace:
Hedgers account for less than 5% of the market, but are the key reason
futures and other such financial instruments exist. The group using these
hedging tools is primarily businesses and other organizations participating in
international trade. Their goal is to diminish or neutralize the impact of
currency fluctuations.
Speculators account for more than 95% of the market.
This group includes private individuals and corporations, public entities,
banks, etc. They participate in the Forex market in order to create profit,
taking advantage of the fluctuations of interest rates and exchange rates.
The activity of this group is responsible for the high liquidity of the Forex
market. They conduct their trading by using leveraged investing, making it a
financially efficient source for earning.
Market making
Since most Forex deals are made by (individual and organizational) traders, in
conjunction with market makers, it’s important to understand the role of the
market maker in the Forex industry.
