Overview
Foreign exchange represents the market for the various currencies adopted by the various sovereign nations. Traders in the foreign exchange market trade one currency for another.
Currency Regimes
Before modeling foreign exchange, one must understand which regime the currency falls under. Currency regimes indicate the degree of a country's intervention in the currency markets with regard to its own currency. Central banks will often intervene in the currency markets, either to make the currency stronger or weaker, or to fix it to another currency in order to acieve stability.
The following are the typical classifications of the different currency regimes.
- Floating - the rate at which two currencies are exchanged is determined by the market
- Fixed - the government guarantees that its currency will exchange at a given rate with some other currency. This requires that the government is able to buy their currency from traders wishing to sell the currency back to the government. This, in turn, requires the government to hold large amounts of the currency to which their currency is pegged.
- Central Bank Intervention - is an intermediate state between fixed and floating, where the currency is allowed to float, but that the central bank is willing to intervene in certain situations.