How Are International Exchange Rates Set?

International currency exchange rates are the values of each nation's currency relative to the values of others. Many of the world's major currencies gyrate in value constantly as they are traded in the foreign exchange markets. The values of others are pegged to another currency or even to a commodity like gold.

In any case, currency exchange rates are critically important to people who are interested in global investing, and to business owners who do business internationally.

Types of Exchange Rates

Currency prices can be determined by a floating or a fixed rate. A floating rate depends on the open market through supply and demand. If demand for the currency is high, the value will increase. If demand is low, this will drive that currency price lower.

That brings into play the economies of every nation with a floating currency. A nation's GDP, the strength of its foreign trade, and the size of its public debt all influence the value of its currency on the open market.

The currencies of most of the world's major economies were allowed to float freely following the collapse of the Bretton Woods system between 1968 and 1973. Therefore, most exchange rates are not set but are determined by ongoing trading activity in the world's currency markets.

Other nations have retained a currency peg, tying the value of their currencies to another country's currency to keep its rate stable.

Factors That Influence Rates

• Floating rates: Rates are determined by market forces and supply and demand. Countless geopolitical and economic announcements affect exchange rates between two countries including interest rate changes, unemployment rates, inflation reports, gross domestic product numbers, manufacturing data, and commodities.
• Fixed or Pegged Rate: A central bank or government determines the rate. The rate is set against another major world currency such as the U.S. dollar, euro, or yen. To maintain its exchange rate, the government buys or sells its currency against the currency it is pegged to.
  
• Macro Factors: The "Law of One Price" dictates that in a world of international trade, the price of a good in one country should equal the price in another. This is called purchasing price parity (PPP). If prices are volatile, the interest rates in a country will shift—or the exchange rate will change between currencies.
• Forex and Commodities: The more dependent a country is on a primary domestic industry, the stronger the correlation between the national currency and commodity prices. Some currencies provide good examples of commodity-forex relationships. The Canadian dollar is positively correlated to oil. As the price of oil increases, the Canadian dollar tends to appreciate against other major currencies. This is because Canada is a net oil exporter; when oil prices are high, Canada tends to reap greater revenues from its oil exports giving the Canadian dollar a boost on the foreign exchange market.

Maintaining Rates

Some countries use a pegged exchange rate set that is maintained artificially by the government. The rate may be reset on particular dates known as revaluation dates.

Governments of emerging market countries often do this to create stability in the value of their currencies. To keep the pegged foreign exchange rate stable, the government must hold large reserves of the currency to which its currency is pegged to control changes in supply and demand.

Extreme short-term moves can result in intervention by central banks, even in a floating rate environment. Because of this, while most major global currencies are considered floating, central banks and governments may step in if a nation's currency becomes too high or too low.

A currency that is too high or too low could damage the nation's economy and even its ability to pay its debts. The government or central bank will attempt to implement measures to move their currency to a more favorable price.

The Bottom Line

Currency prices are determined in two ways: fixed rates and floating rates. Fixed rates are pegged to a currency while floating rates move freely with market demand. Nations attempt to manipulate their currencies to remain strong and demand for their currency is high in foreign exchange markets.