Trades on the foreign exchange market are subject to a myriad of rates, and the success of an investor’s forex trading efforts hinges on understanding which one applies during a transaction. People who travel abroad need a keen grasp of exchange rates as well, as mistakes could lead to serious financial trouble. Exchange rates vary depending upon the currency system in which the trade is occurring, the financial instruments used in the transfer, the timing of the purchase and who’s conducting it.
Foreign exchange rates are commonly classified as either filed or floating currency systems. In a fixed system, exchange rates are tied to 'hard' assets such as precious metals, while in a floating currency system rates are allowed to fluctuate alongside general supply and demand.
Fixed Currency Systems Vs. Floating Currency Systems
Currency systems – also known as exchange rate regimes – usually operate under either a fixed-rate or floating-rate basis. Countries that utilize a fixed system, such as the United States, tie rates to precious metals, goods or another currency. Floating systems, like the one used in Brazil, allow rates to fluctuate with the oscillations of supply and demand for that particular currency. Some countries, including China, operate their currency system as hybrids of the two, with rates being tied to fixed assets while still being able to shift within a certain range. Because foreign exchange rates can be subject quick changes, you’ll have to keep in mind which system you’re trading – or traveling – under, and keep track of the overall market in that country.
Differing Financial Instrument Rates
Another important factor in foreign exchange rates is the financial instrument that’s used in the exchange. Cash, check and credit card exchanges all have different rates, with higher rates existing for instruments that require more processing. For example, cash transactions have a lower exchange rate than checks because there is no need to wait for the funds to clear and become available to the buyer. Likewise, trades made by credit card have a higher exchange rate than those made by debit card, as there are additional fees and processing requirements for credit transactions, while debit purchases are treated similar to cash and applied instantaneously.
The spot rate is the most common figure investors and travelers encounter. It’s the rate of exchange for immediate – on the spot – trades, as opposed to trades scheduled to go through at a point in the future. Spot trades have a two-business-day transaction time, but the rate is still set on the day the trade is initiated.
Exchanges that are planned in the present, but are actually executed at some point in the future, are carried out at the forward rate. The rate is set at the time the exchange is planned, and it’s usually a few points above or below the spot rate, depending on how the market thinks the currency will be valued in the future. Forward rates offer a good way to hedge against losses that can occur from currency fluctuations, as buyers can lock in a price and know exactly how much a trade will cost them down the road.
Some countries employ different rates depending on the entities involved in the exchange. These currency systems often have a two-tier setup with floating rates for trades conducted by private commercial entities and fixed rates for exchanges involving “essential” or governmental bodies, including importers and exporters. Rates for vital entities also are often higher to encourage these kinds of transactions.
Lauren Treadwell studied finance at Western Governors University and is an associate of the National Association of Personal Financial Advisors. Treadwell provides content to a number of prominent organizations, including Wise Bread, FindLaw and Discover Financial. As a high school student, she offered financial literacy lessons to fellow students.