When trading on Forex markets, it is very important to understand different exchange rate regimes which countries have adopted. The main types are as follows: a floating exchange, a pegged floating exchange, and a fixed rate exchange.
The floating exchange rate regime is the most popular one and is adopted in many different countries. The USD, EUR, JPY, GBP are all examples of currencies that are floating freely. In these instances, market participants are determining current rates through increasing/decreasing supply or demand. Central banks sometimes intervene in free market operations in order to minimize excessive volatility in the value of a currency. Some commentators would use the term “managed float” in these cases.
A pegged float regime is a system of pegging a country’s currency to a band or value, which may be fixed or periodically adjusted. A peg helps importers and exporters to minimize their exchange rate risk allowing them to plan safely enough regarding their future trade operations. It is also helps to ease the inflationary pressures. Danish krone (DKK) is an example of this type of currency. It is pegged to EUR using the so called European Exchange Rate Mechanism (ERM) II which allows a currency to float within +-15% against EUR. However, Denmark’s National Bank uses a narrower range of +/-2.25% and now, with EUR depreciating they still wish to keep the peg and are not allowing DKK to appreciate. The Danish government has even suspended bond issuance in order to protect the peg.
Fixed exchange regime doesn’t allow currency to fluctuate whatsoever. A country’s Central Bank would use open market mechanisms in order to maintain the fixed pegged ratio. China was the last large economy that was using this type of exchange rate regime, but in July 2005 it decided to move towards more flexible system. It is crucial to understand the rules that governments use and how these rules affect currencies in order to spot great opportunities to enter the markets.