What Is A Floating Exchange Rate System & How Can It Affect Your Trades?
The currency and foreign exchange market is one of the most unique and unusual to trade in, filled with opportunities to apply not only technical financial knowledge but also geopolitical awareness and a degree of intuition in order to make financial gains.
Because there are so many avenues for success when it comes to forex trading, particularly if you are part of an instant funding prop firm which allows you to make impactful trades very quickly, it is important to understand how the market works and why exchange rates change so rapidly.
Most currencies operate using a floating exchange rate system and have done so for nearly half a century.
What is a floating exchange rate? Where did it come from? Why has it become the preferred exchange rate system, and how can forex traders navigate it to make gains?
What Is A Floating Exchange Rate?
A floating exchange rate is a system where the value of a currency is linked to supply and demand. In other words, the forex market decides how much a currency is worth in relation to other currencies.
If the demand for a given currency is high, usually during economic boom periods where people are more willing to spend, and the rate of inflation is relatively low, the value will gradually rise, whilst the opposite will happen if the demand is low relative to supply.
Floating Exchange Rates Vs Fixed Exchange Rates
The alternative way to manage the value of a currency is either outright fixed exchange rates or rates pegged to another asset, often a curbasket of currencies or a precious commodity such as gold or silver.
The gold standard is a form of fixed exchange rate, where a given currency’s value is pegged against the value of gold on the open commodities market. As gold is a relatively stable store of value, this approach traditionally led to relatively stable exchange rates.
A fixed exchange rate system is centrally managed, is typically linked to the market price of another asset and often relies on having a large pool of reserves to help keep the currency within a narrow band.
This is especially true for currencies which have somewhat unrealistic fixed rates relative to their market value, and many of these potential weaknesses led to the modern floating exchange rate system in more economically developed countries.
Where Did Floating Exchange Rates Come From?
Why did this change? There are a lot of reasons, but the biggest is the breakdown of the biggest and most widely used fixed exchange rate system in the world.
What Was Bretton Woods?
The Bretton Woods System is the final form of the gold standard as a major international currency exchange system.
How it worked was that any country that agreed to the system would need its currency to be pegged to the price of the US dollar, which was itself pegged to the price of gold.
The idea was to avoid the issues with competitive devaluations, promoting growth after the devastation of the Second World War and avoiding the complications that emerged when countries had to abandon the gold standard after the First World War.
Under Bretton Woods, the dollar was convertible to gold at a rate of $35 to a troy ounce, which then in turn gave the dollar a relatively fixed value that other currencies were pegged against and were required to remain within one per cent.
Why Did Bretton Woods Collapse?
Bretton Woods, despite establishing the World Bank, International Monetary Fund and the foundations of the modern forex market, was ultimately both short-lived and a failure in the long term.
The adjustment aspect of Bretton Woods would lead to “stop-go” economic policies to try to fix it. This was most visible in the United Kingdom, which raced from expansionary policies to sudden austerity.
The United States dollar, by being the standard currency that every other forex market had to interact with, did not have any of these restrictions or requirements to adjust.
At the same time, however, there were liquidity concerns which forced the USA to run at a deficit in order to keep the system running with its relatively fixed exchange rates.
Ultimately, the problems were exposed when gold prices increased above the $35 an ounce price, which created huge potential problems that could only be fixed by increasingly protectionist measures.
This in itself created a no-win situation where maintaining liquidity would affect the confidence of the dollar and potentially cause a run on the USA’s gold reserves.
The solution domestically was to implement inflationary policies, but this doomed Bretton Woods to break down. There was a run on the pound sterling in 1967, and the collapse of an eight-nation gold pool in London in 1968.
By 1971, the system had all but collapsed, replaced by floating exchange rates for most of the nations under Bretton Woods. However, some countries still use fixed exchange rates today, typically through pegs to the US dollar or a basket of currencies, as the United Arab Emirates does.
How Do Floating Exchange Rates Affect Forex Traders?
Currencies which use floating exchange rates have few, if any, restrictions surrounding how they are traded, with the market open five and a half days a week.
Ultimately, floating exchange rates are both liquid and relatively volatile; the price will rise and fall in relation to supply and demand, with bigger pip shifts appearing in relation to speculation, major national and international events, rumours surrounding fiscal policy and diplomatic relations.
Are High-Value Currencies Always Good?
Ultimately, a currency with a high value is not always positive, as high values can affect the ability of a nation to trade with others, as it becomes expensive to export goods. Usually, this is when a currency is intentionally devalued to maintain trade competitiveness and will inevitably lower.
Are Low-Value Currencies Always Bad?
Similarly, whilst a low-value currency can seem bad on paper, it means that there is a greater likelihood that international investors will invest due to the relatively low cost of doing so.