How Are International Exchange Rates Set?

International currency exchange rates display how much one unit of a currency can be exchanged for another currency. Currency exchange rates can be floating, in which case they change continually based on a multitude of factors, or they can be pegged (or fixed) to another currency, in which case they still float, but they move in tandem with the currency to which they are pegged.

Knowing the value of a home currency in relation to different foreign currencies helps investors to analyze assets priced in foreign dollars. For example, for a U.S. investor, knowing the dollar to euro exchange rate is valuable when selecting European investments. A declining U.S. dollar could increase the value of foreign investments just as an increasing U.S. dollar value could hurt the value of your foreign investments.

Floating rates are determined by the market forces of supply and demand. How much demand there is in relation to supply of a currency will determine that currency's value in relation to another currency. For example, if the demand for U.S. dollars by Europeans increases, the supply-demand relationship will cause an increase in price of the U.S. dollar in relation to the euro. There are countless geopolitical and economic announcements that affect the exchange rates between two countries, but a few of the most common include interest rate changes, unemployment rates, inflation reports, gross domestic product numbers, manufacturing data, and commodities.

Generally, the more dependent a country is on a primary domestic industry, the stronger the correlation between the national currency and the industry's commodity prices.

There is no uniform rule for determining what commodities a given currency will be correlated with and how strong that correlation will be. However, some currencies provide good examples of commodity-forex relationships.

Consider that the Canadian dollar is positively correlated to the price of oil. Therefore, as the price of oil goes up, 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.

Another good example is the Australian dollar, which is positively correlated with gold. Because Australia is one of the world's biggest gold producers, its dollar tends to move in unison with price changes in gold bullion. Thus, when gold prices rise significantly, the Australian dollar will also be expected to appreciate against other major currencies.

Some countries may decide to use a pegged exchange rate that is set and maintained artificially by the government. This rate will not fluctuate intraday and 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 of the country must hold large reserves of the currency to which its currency is pegged to control changes in supply and demand.