Page 53 - Ultimate Guide to Currency Trading

spoken about on news sources such as CNBC and Bloomberg. As you can see, the idea of where the
interest rate for a currency is heading is key to making good trades.

More Currency Fundamentals

There are three forms of currency management that a central bank can undertake to regulate and
control its home currency. One method is to forcibly link the value of the home currency to the value
of a stronger currency. This method is called pegging and is done in many developing countries, such
as those in Latin America and Asia. When a currency is pegged to another, its exchange rate is fixed.
Not only that, but its growth rate and volume of money in circulation can also be related to the like
amounts in the other country's economy. This is true because the home country's money value will be
related to other currencies in the same up-and-down fashion as the movement of the assumed
currency.

For example, China has long pegged its currency's exchange rate to the U.S. dollar. This means
that the Chinese yuan is always the same value of a certain number of U.S. dollars. Since the value of
the two is fixed, if the value of the USD goes down against the EUR, the value of the Chinese yuan will
go down against the value of the EUR by the same amount. This technique of pegging the Chinese
yuan to the USD has worked especially well for the Chinese economy. This is partially because the USD
is the largest currency in volume of all the traded currencies in the world (over 62 percent in 2010) as
reported on the Bank for International Settlements website (www.bis.org/ publ/rpfx10t.htm).

Some currencies are managed in a monitored float that is similar to one that is
pegged. The difference is that the currency is constantly adjusted to the benefit of the
home country. A committee will usually adjust the rate of exchange up or down
Essential according to the home country's immediate needs. This is often called a "dirty float."

Many people believe that the reason the USD/CNY peg has worked so well for the Chinese
economy is that the peg has historically been set at an artificially low rate, which in turn, many believe,
has helped make China more competitive in the world market. This is one example of an effective use
of a pegged currency.

Dollarization

The second method of monetary management that central banks can put into place is a method of
dollarization. This is the method where a country's central bank gives up all control of its currency to
the point of adopting the currency of another nation. The home country will usually adopt the
currency of a neighbor that is a heavy-trading partner and has a history of economic stability.