Being the main force driving the global economic
market, currency is no doubt an essential element for a country.
However, in order for all the countries with different currencies
to trade with one another, a system of exchange rate between their
currencies is needed; this system, is formally known as foreign
exchange or currency exchange.
Introduction to Foreign Exchange Markets
In the early days, the system of currency exchange is supported
solely by the gold amount held in the vault of a country. However,
this system is no longer appropriate now due to inflation and
hence, the value of one’s currency nowadays is determined
through the market forces alone. In order to determine the value
of a currency’s exchange rate, two main types of system
is used which is floating currency and pegged currency.
For floating exchange rate, its value is determined by the supply
and demand of the global market where the supply and demand is
bound by all these factors such as foreign investment, inflation
and ratios of import and export. Normally, this system is adopted
by most of the advance countries like for example UK, US and Canada.
All of these countries have a similarity where their market is
well developed and stable in economic terms. These countries choose
to practice this system due to the reason where floating exchange
rate is proven to be much more efficient compared to the pegged
exchange rate. The reason behind this is because for floating
exchange rate, the market itself will re-adjust the exchange rate
real-time in order to portray the actual inflation and other economic
forces. However, every system has its own flaw and so does the
floating exchange rate system. For instance, if a country suffers
from economic instability due to various reasons such as political
issues, a floating exchange rate system will certainly discourage
investment due to the high risk of suffering from inflationary
disaster or sudden slump in exchange rate.
Another form of exchange rate is known as pegged exchange rate.
This is a system where the value of the exchange rate is fixed
by the government of a country and not the supply and demand of
the market. This system is called pegged exchange rate because
the value of a country’s currency is fixed to another country’s
currency. As a result, the value of the pegged currency will not
fluctuate unlike the floating currency. The working principle
behind this system is slightly complicated where the government
of a country will fixed the exchange rate of their currency and
when there is a demand for a certain currency resulting a rise
in the exchange rate, the government will have to release enough
of that currency into the market in order to meet that demand.
However, there is a fatal flaw in this system where if the pegged
exchange rate is not controlled properly, panics may arise within
the country and as a result of that, people will be rushing to
exchange their money into a more stable currency. When that happens,
the sudden overflow of that country’s currency into the
market will decrease the value of their exchange rate and in the
end, their currency will be worthless. Due to this reason, only
those under-developed or developing countries will practice this
method as a form to control the inflation rate.
However, the truth is, most of the countries do not fully practice
the floating exchange rate or the pegged exchange rate method
in reality. Instead, they use a hybrid system known as floating
peg. Floating peg is the combination of the two main systems where
one country will normally fixed their exchange rate to the US
Dollars and after that, they will constantly review their peg
rate in order to stay in line with the actual market value.
The Foreign exchange market, or commonly known as FOREX, is the
largest and most prolific financial market because each day, more
than 1 trillion worth of currency exchange takes place between
investors, speculators and countries. From this, we can deduce
that the actual mechanism behind the world of foreign exchange
is far more complicated than what we may already know, and that,
the information mentioned earlier is just the tip of an iceberg.