Describe the main types of foreign exchange rate system. Briefly discuss how such systems might affect the ability of financial managers to forecast exchange rates.

Advanced Financial Management Block Revision Mock Exams

Although two of the world‟s leading trading currencies, the US dollar and the Japanese yen are floating against other currencies, floating exchange rates are used a minority of countries. A wide variety of exchange rate mechanisms exist. These include:

(i) Fixed or pegged exchange rates where a country fixes its exchange rate against the currency of another single country. More than 50 countries fix their rates in this way, mostly against the US dollar. Fixed rates are not permanently fixed and periodic revaluations and devaluations occur when the economic fundamentals of the countries concerned strongly diverge (e.g inflation rates).

(ii) Fixed exchange rates against a basket of currencies, the basket often being devised to reflect the major trading links of the country concerned. Using a basket of currencies is aimed at fixing the exchange rate against a more stable currency base than would occur with a single currency fix.

(iii) Flexible exchange rates against a single currency within a limited range of flexibility.

(iv) A joint float of a group of currencies. Prior to monetary union the currencies within the exchange rate mechanism (ERM) of the European Union participated in a joint float against external

currencies, whilst maintaining a flexible exchange rate within agreed ranges against other ERM members.

(v) Automatic exchange rate adjustments against a set of economic indicators.

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