Five things you should know about exchange rates

segun akande

February 23, 2017 8:58 AM

They seem like simple differences in value of currencies but the rates are an important sign of an economy's health.

In the last few months, exchange rates have become an important part of our conversations. Either from trading with foreign merchants or buying commodities produced in foreign countries, everyone feels the effect of fluctuating exchange rates in one way or the other.

On the surface, they may simply feel like the differences in value of currencies, but they play an important role in the overall mechanism of any economy. Here are 5 things you should know about exchange rates.

1) In the simplest terms, an exchange rate is the value for which one currency will be exchanged for another. For example, an interbank exchange rate of one dollar to 500 naira means that a dollar will be exchanged for 500 naira. In financial circles, the exchange rate is also referred to as forex, fx rate, ER or Agio.

2) National currencies are important to the way the modern economy works because represent the value of commodities across different countries. Because it is mostly impossible to trade in most countries using foreign currencies, exchange rates express the cost of one currency in the form of another. For example, an exchange rate of one dollar to 500 naira simply means that one dollar costs 500 naira.

3) There are two ways of determining a country's exchange rate; a floating currency and a pegged currency. The floating currency is determined by the strength of the economy, its policies and the market forces of demand and supply. Quite simply, it is worth whatever the market's players are willing to pay for it.

4) A pegged currency, on the other hand, is fixed by the government's apex financial and currency body, such as the CBN in Nigeria. This body has to work hard to ensure that the economy is strong enough to support this rate, it does this by holding large foreign reserves in order to react to fluctuations caused by market forces and other factors such as inflation, supply and demand.

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5) Exchange rates are usually a function of the economy's strength but other factors play important roles in the strength of a currency in relation to another. A currency's value may be determined by inflation rates, interest rates, the country's balance of payments, government debt, speculation among investors and recession.

segun akande