How to Measure Types of Exchange Rates:

In a world moving towards increasing globalisation, exchange rates play a significant role in determining the value of one currency relative to another. Although it may not seem like it, the value of exchange rates is crucial for all in the economy, including businesses, investors, policymakers and individuals. This is because they can affect the cost of any trade or financial flows travelling to a different country. Furthermore, exchange rates can be measured against each other in various different ways. There are two different types of exchange rate systems:

Bilateral Exchange Rates

This method is the most straightforward. Bilateral exchange rates refer to the direct comparison of one country's currency against another. Commonly, currencies are compared against the USD due to its widespread use in global trade. For example, if the AUD/USD exchange rate is 0.75, this means that 1 Australian Dollar is equivalent to 75 US cents. The following graph displays the value of the Australian dollar to the US dollar over the last half decade:

Trade Weighted Index (TWI)

The TWI of a country provides a broader perspective of their currency's performance relative to their trading partners. The TWI therefore is considered a "basket of currencies," which contain the currencies of Australia's major trading partners. The Reserve Bank of Australia (RBA) calculates the TWI for the Australian dollar using a basket of 21 currencies, with weights based on the share of trade between Australia and each country. This provides a more comprehensive overview of the strength of a country's currency by smoothing out the volatility seen in bilateral rates because it incorporates a range of currencies, some of which may move in opposite directions.

The following pie chart demonstrates the significance each of Australia's major trading partners' currency involves in the calculation of its TWI.

Cross Rates

Cross rates are another useful exchange rate measurement, particularly for currencies that do not directly trade against each other. These rates are derived from their common exchange rates with a third currency (usually the USD). For instance, the EUR/AUD rate can be calculated if the EUR/USD and AUD/USD rates are known, allowing businesses and investors to gauge the relative value of these currencies without direct exchange. For example, the following chart displays the cross rates between the Australian dollar and the Euro over the last half decade.

Fixed Rates

In a fixed exchange rate system, a country's currency value is tied or pegged to another major currency, such as the U.S. dollar, the euro, or a basket of currencies. The government or central bank of the country intervenes in the foreign exchange market to maintain the currency's value within a narrow band or at a specific level relative to the anchor currency. This is done by the country's central bank, which actively buys and sells its own currency on the foreign exchange market to maintain the fixed rate.