The Pros and Cons of Floating Exchange Rates
Trading forex is all about currency rates, which can follow either a fixed or a floating exchange rate system. Since concepts are often best understood by their opposites, let’s briefly look at the fixed exchange rate system.
When we talk about a fixed exchange rate, it means one currency is pegged to another currency. Whereas, in a floating exchange rate system, one currency’s value is determined by its demand and supply in the foreign exchange market in comparison to the other currency.
Most large economies today use a floating exchange rate system. According to the BIS Triennial Survey released in September 2025, the foreign exchange market reported a daily turnover of $9.6 trillion¹ in April 2025.
The main characteristic of a floating exchange rate is exchange rate volatility. This presents opportunities as well as risks for traders. If we shed some light on the positive side, floating rates generally reflect market perceptions of economic conditions, though they may also be influenced by speculation and short-term sentiment. They provide nations with more flexibility and monetary policy independence.
On the flip side, volatility presents greater uncertainty for firms that operate in international trade and exposes risks to economies with less robust financial systems.
The information in this article is provided for educational purposes only and does not constitute financial advice. Consult a financial advisor before making investment decisions.
Floating Exchange Rate: An Introduction
To float a currency is to make the exchange rate of a currency fully liberalised. In this case, the government or the central bank does not interfere in setting it directly. Rather, it is automatically determined in the currency market through supply and demand mechanism that sets the national currency's exchange rate against foreign currencies.
In the floating rate system, the value of currencies fluctuates constantly with every change in the supply and demand dynamics.
The supply and demand for a currency are affected by a number of factors, including but not limited to:
- Global trade
- Interest rates
- Foreign and international investment
Any or all of these factors may have a significant impact on the value of a currency in the international forex market.
A floating currency rate is often left to be determined only by market supply and demand, but it can also be limited. When a floating exchange rate is limited, the government (through its central bank) intervenes as needed in order to manage the exchange rate when it becomes too high or too low, typically by adjusting the supply or demand for foreign currencies.
Fixed vs Floating Exchange Rates: Key Differences
As we discussed until now, exchange rates define how one currency is valued against another, and countries typically adopt either a fixed or a floating exchange rate approach.
- A fixed exchange rate is set by a government or central bank, often linked to another currency or commodity. This can include systems like a currency board, where the local currency is fully backed by reserves.
- On the contrary, a floating exchange rate system allows market supply and demand to influence currency values. Many nations also use a managed float, where central banks intervene occasionally to limit excessive volatility.
Historically, the gold standard represented a strict fixed system. Then, in the 1970s, the shift toward floating marked a global turning point. Today, Hong Kong operates a currency board pegged to the USD. Saudi Arabia, as part of the petrodollar system, maintains a long-standing peg of the Saudi riyal (SAR) at around 3.75 per US dollar, ensuring oil revenues are stabilised in USD terms.
On the other side, the US, the UK, Japan and many other countries let their currencies float, with exchange rates moving daily in global markets.
How Does a Floating Exchange Rate Work?
The forex market is known to be the largest financial market in the world, open 24/7 a day, five days a week. On a daily basis, it records a turnover of over $9.6 trillion, which indicates at what scale the market operates.
Under a floating exchange rate system, the value of a currency is largely determined by market forces, specifically the price at which one currency can be exchanged for another. This exchange occurs whenever traders, individuals, businesses, or investors buy or sell currencies for trade, investment, or other financial purposes, leading the currency rates to constantly fluctuate.
- Higher demand may lead to currency appreciation
- Lower demand may result in depreciation
There may also be a case of exchange rate equilibrium. It is achieved when buying and selling pressures roughly balance. Though the balance may shift quickly due to several factors including but not limited to economic data releases, interest rate changes, or geopolitical events.
Floating currencies may be advantageous when an economy is stable and monetary policy is credible. However, negative market sentiment toward the government or its policies may possibly lead to devaluation. Thus, central banks may intervene occasionally by purchasing or selling currency to level out excessive volatility.
If you are a forex trader, it’s good to remember that market volatility under floating regimes may be pronounced, especially following unexpected policy decisions or global macroeconomic shocks. Hence, traders may consider risk management strategies, such as stop-loss orders or hedging, to help mitigate potential losses; however, these can manage but not fully eliminate risk.
Advantages of a Floating Exchange Rate
Let's consider some of the possible advantages of a floating currency and how it may help a nation's economy and could promote trade and investment.
Balance of Payments (BOP)
The Balance of Payments often plays an important role in the local currency exchange rate. It refers to a statement of transactions between one country and the rest of the world during a specified period of time. In cases where there is a deficit, the currency may depreciate, lowering the cost of the country’s exports. In contrast, a balance of payments equilibrium may help stabilise the currency and maintain investor confidence.
In the case of depreciation, foreign investors may find domestic assets more attractive, which could attract investment. However, this effect is not automatic or guaranteed; it depends on other macroeconomic factors, investor confidence, and global market conditions.
The market determines the exchange rate
Floating exchange rate currencies are exchanged in the currency markets with little active intervention from governments or central banks. So, the price discovery is done in an open market.
High market efficiency
When currencies are based on a floating exchange rate, they may allow for more flexible cross-border investment and could potentially have positive effects on a country’s economy and domestic production, depending on broader economic conditions.
Does not require large foreign currency reserves
With a floating rate, central banks may not need to hold large amounts of foreign exchange reserves for the purpose of defending a fixed rate, because the market determines the rate. Hence, reserves might instead be used elsewhere.
Protection from import inflation
Import inflation may sometimes occur in countries with fixed exchange rates, particularly if the currency is overvalued. Countries with floating currencies may experience more flexible adjustment of currency values, but this does not automatically prevent import inflation.
Risks of a Floating Exchange Rate
Let’s look at the risks of floating currency.
Risk of volatility
Floating currencies are subject to fluctuations and are not predictable by default. One currency can decline in value against another currency within a single trading day. While short-term fluctuations are difficult to forecast, longer-term patterns may still be influenced by macroeconomic fundamentals such as interest rates, inflation, and trade balances.
Impact on trade
If a currency depreciates, imports from other countries may become more expensive while exports may become more competitive.
Government Intervention in a Floating Exchange Rate
Foreign exchange intervention refers to actions taken by a central bank to influence the value of its currency.
But how do central banks intervene? Well, it can be either direct intervention (like buying and selling of currencies) or indirect intervention (such as modification of interest rates or monetary policy).
A managed float is a hybrid regime where the currency is allowed to float to a significant extent, but the central bank occasionally intervenes to stabilise it.
China's monetary policy, managed by the People's Bank of China, is one example of intervention under a managed float regime. Its central bank could intervene and manipulate the exchange rate of the yuan. This affects trade by devaluing the currency to make exports cheaper and possibly boost domestic production.
Similar to China, there are a few more nations that practice a managed float system. Let’s look at them.
- Japan: The Bank of Japan has intervened multiple times to support the yen, particularly when it declines steeply against the US dollar.
- Switzerland: The Swiss National Bank has intervened aggressively to buy foreign currencies to cap the franc's appreciation. In just one quarter from April to June 2025, it bought approximately 5.06 billion francs ($6.36 billion), the highest in over three years.
- India: Reserve Bank of India utilises its Forex reserves to stabilise rupee volatility, and as a rule, it sells US dollars when the currency loses value.
Examples of Major Floating Currencies
Some of the world's largest economies have free-floating currencies, whose values are determined largely by market forces and not central bank intervention. These are significant participants in global financial markets and tend to reflect different levels of currency volatility.
- US Dollar (USD): The most widely traded and held reserve currency in the world. It tends to strengthen when there is uncertainty throughout the world, as investors flock to it as a safe haven.
- Euro (EUR): The second most widely traded currency, driven by economic indicators and policy announcements of the European Central Bank.
- British Pound Sterling (GBP): Known for higher volatility, often reacting sharply to political and economic news from the UK.
- Australian Dollar (AUD) and Canadian Dollar (CAD): Strongly correlated with global commodity prices.
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Frequently Asked Questions (FAQ)
What does a floating exchange rate mean?
A floating currency price can be left to be determined only by market supply and demand without a fixed peg to another currency.
What are the advantages of a floating exchange rate?
Here are the advantages of a floating exchange rate.
- It does not require large foreign currency reserves
- Exchange-rate movements can help absorb external price shocks, potentially limiting inflation driven by higher import prices.
- It also reflects true market conditions in real time
How volatile are floating exchange rates?
Floating currencies may fluctuate daily. Volatility depends on factors like trade balance, interest rates, macroeconomic factors, currency speculation and investor sentiment.
Which countries use floating exchange rates?
Major economies with floating systems include the United States, the Eurozone, the United Kingdom, Australia, and Canada.
Source:
¹ https://www.bis.org/statistics/rpfx25_fx.htm
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