How is the exchange rate determined and who regulates it?

Every day we hear about exchange rates in the financial news. This data is used in everyday life when planning overseas trips, shopping internationally, and building foreign currency savings to protect against inflation. Forex traders also deal with fluctuations in currency pairs on a daily basis, analyzing quote charts for the most profitable deals, assessing the economic state of countries and predicting future trends in the market.

But how exactly is the exchange rate formed? What does the euro rate depend on and what does the dollar rate affect? Let’s understand where quotes come from and who determines their value.

What is the exchange rate?

The exchange rate is the value of one currency expressed in units of another. This price is constantly changing on the chart, creating so-called quotes. In Forex, currency pairs are labeled as follows:

XXX/YYY

where XXX is the currency whose rate is being determined and YYY is the currency in which the value is calculated. For example, if the EUR/USD exchange rate is 1.2300, it means that 1 euro is worth 1 dollar and 23 cents.

Factors affecting the exchange rate

A lot of factors affect the exchange rate:

  • Supply and demand. Currencies are bought and sold like commodities, and investor interest determines their value.
  • Economic indicators. Inflation, unemployment rate, GDP, and other indicators gauge a country’s economic strength and stability.
  • Monetary policy. Central banks’ decisions on interest rates and money supply management affect inflation and confidence in a nation’s currency.
  • Political and economic stability. Emergencies such as wars, sanctions, crises, and natural disasters can cause capital outflows and alter currency exchange rates.
  • Global market events. Changes in sentiment in financial markets, especially those related to the currency of interest, also affect quotes.

Who shapes the exchange rate?

The most objective ratio of currency values is established in financial markets, where supply and demand reflect the reaction of market participants to global events. Private traders make money on the difference in exchange rates by buying currency cheaper and selling it more expensive through intermediaries – brokers. The exchange rates we see in the news are set by the Central Bank on the basis of transactions on the Moscow Exchange. These are average values of currency value calculated on the basis of trading results, and they serve as a benchmark for exchange operations in the country.

Who regulates exchange rates?

Central banks or similar government organizations regulate exchange rates. They use various instruments:

  • Interest rates. Rising rates strengthen a currency, making it attractive to investors, while falling rates in a crisis help stabilize the economy.
  • Open market operations. Central banks can use internal reserves to intervene in exchange rate movements.
  • Money supply control. Regulating the amount of money in circulation affects inflation and the exchange rate.
  • Currency interventions. In cases of severe volatility, central banks can stabilize the market.
  • Currency regimes. Countries can choose different policies for free floating and convertible currencies, from fully floating to fixed exchange rates.

Forex trading process

Forex (Foreign Exchange Market) is one of the largest and most liquid financial markets in the world. It is an over-the-counter market and has no specific location. The rates of currency pairs are determined by the supply and demand of market participants, including central banks, commercial corporations, investment funds and private traders. Each participant influences the quotes in its own way depending on the volume of transactions and strategies.

Conclusion

We have understood how the exchange rates we see in trading terminals, news and exchange offices are formed. This process involves many large financial organizations, companies and private investors whose actions affect the quotes. Understanding the factors that influence exchange rates is important for analyzing and predicting the market, as well as managing the risks associated with their fluctuations.

History of Forex

Bretton Woods Agreement

In 1967, the Chicago Bank refused to make a loan in pounds sterling to Professor Milton Friedman, who planned to use the funds to sell British currency. Friedman believed that sterling was overvalued against the dollar and intended to sell the currency and then buy it back at a lower rate to repay the loan and make a profit. The bank’s refusal was based on the provisions of the Bretton Woods Agreement, made twenty years earlier, which fixed exchange rates against the dollar, and the dollar against gold, set at $35 per ounce.

The Bretton Woods Agreement was signed in 1944 to maintain financial stability in the world by limiting capital flows and currency speculation. Prior to this, from 1876 until World War I, the international economic system was based on the “gold standard,” in which currencies were tied to the price of gold. This provided stability by eliminating the practice of currency devaluation and inflation.

However, the gold standard had its drawbacks. Economic growth in one country increased imports, which reduced its gold reserves and reduced the money supply. This raised interest rates and slowed economic activity until a recession hit. Then prices fell, goods became attractive to other countries, causing gold to flow in, increasing the money supply and lowering interest rates, contributing to an economic recovery. Such cycles dominated until World War I disrupted trade flows and the free movement of gold.

After the two world wars, the Bretton Woods Agreement was established whereby countries pledged to keep the exchange rates of their currencies within narrow limits relative to the dollar and gold. Devaluation of currencies to gain trade advantages was forbidden, except up to a maximum of 10%. In the 1950s, with the increase in international trade brought about by the post-war recovery, there were significant capital movements that destabilized the exchange rates set at Bretton Woods.

In 1971, the agreement was finally abolished and the U.S. dollar was no longer convertible into gold. By 1973, the currencies of the major developed countries began to float freely, controlled by supply and demand in the international foreign exchange market. Trade volumes, speed and price volatility increased substantially in the 1970s, leading to the creation of new financial instruments and trade liberalization.

In the 1980s, with the advent of computers and new technologies, international capital movements increased, blurring the boundaries between Asian, European and American time zones. Trading volume in the international foreign exchange market grew from about 70 billion dollars a day (in the 1980s) to over 1.5 trillion dollars a day two decades later.

Euro market

One of the main catalysts for the development of the international foreign exchange market was the rapid expansion of the Euro-dollar market, where U.S. dollars were deposited in banks outside the United States. Other Euro markets developed in a similar manner when currencies were deposited outside their country of origin. The Euro-dollar market emerged in the 1950s when the USSR deposited oil revenues in dollars outside the US for fear of the US authorities freezing the accounts. This contributed to the significant growth of dollars out of U.S. control. The U.S. government enacted laws restricting the lending of dollars to foreigners. Euro markets were particularly attractive because of less regulation and higher returns.

Beginning in the late 1980s, U.S. companies began borrowing abroad, finding the Euro market advantageous for placing excess liquidity, obtaining short-term loans, and financing foreign economic activity. London was and remains the main center of the euro market. In the 1980s, British banks began actively providing dollars as an alternative to pounds in order to maintain their leading position in the global financial market. London’s convenient geographical location, allowing it to work with both Asian and American markets, also contributed to its dominance in the euro market.

What is Stop-Loss and Take-Profit: calculation and use on Forex

Trading on the financial market is associated with high risk due to rapid fluctuations in asset prices. Many traders, unfortunately, do not manage to strictly follow the rules of money management, which they read about in training materials. As a result, trades are often opened for a significant part of the deposit.

Nevertheless, traders usually adhere to risk management by setting Stop-Loss and Take-Profit levels for each trade. These tools are available for free on all trading platforms.

What is Stop-Loss and Take-Profit?

Take-Profit is the level at which a trade is automatically closed, locking in profit. Stop-Loss, on the contrary, is designed to minimize losses by automatically closing a deal when it reaches a specified level.

These tools protect the trader from large losses. However, it should be taken into account that in rare cases slippages may occur, in which it is impossible to close the position at the specified price.

Setting Stop Loss and Take Profit levels

Initially, setting these levels may seem like a simple task. However, to determine the optimal levels, you need to analyze the dynamics of asset prices and take into account many nuances.

Some traders set stop loss and take profit only at the beginning of their career. However, it is important to remember that even with constant monitoring of the chart, the situation can change instantly, turning a profit into a loss.

Stop loss operation

A stop-loss is an order to the broker to close a position when it reaches a certain level. It remains active even without your participation, automatically closing the position if the price goes against you.

There are three main types of stop losses:

  1. Percentage Stop – based on a percentage of the trade amount.
  2. Chart Stop – based on technical analysis.
  3. Volatility Stop – takes into account the volatility of the market.

Take Profit work

Take Profit is an order to the broker to close a deal when a certain profit level is reached. It helps to fix the profit, preventing its loss when the market situation changes.

Calculation of Stop Loss and Take Profit

Traders have access to free online calculators on brokers’ websites to calculate these levels. It is important to determine the size of the potential loss and profit, as well as calculate the change in balance when the price changes by one point.

Calculation example

Suppose you open a position to buy one lot of USDCHF at the price of 1.6815, with the target levels of Take Profit $120 and Stop Loss $60. To calculate the pip value, multiply the lot by the price step and divide by the current rate:

Cost per pip = (100,000 x 0.0001) / 1.6815 = 5.95 USD

By setting take profit at 20 pips from the current price, your profit will be $119. A stop loss of 10 pips from the current price will result in a loss of $59.5.

Setting levels in MetaTrader 4

To set stop loss and take profit:

  1. Open MetaTrader 4.
  2. Click “New Order”.
  3. Select the asset, position volume and execution type.
  4. Enter the Stop Loss and Take Profit values.
  5. After opening a position, go to the “Trade” tab, right-click on the position and select “Modify or Delete Order”.

Conclusion

Stop loss and take profit are key risk management tools. It is important that their setting is in line with your strategy and technical analysis. Even if you are confident in the forecast, it is better to reinsure yourself and protect your deposit.

Emotions can be a trader’s enemy, and using these tools helps to preserve capital in unpredictable situations.