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Interest rates and exchange rates are an everyday part of the world’s economic life. Any time that currency is borrowed, loaned, or exchanged for another type of currency, these rates come into play. These rates can be fixed at a certain value, or can be free to change with market fluctuations and other changing conditions. A rate that changes with market conditions on a periodic basis is called a floating rate.
The three contexts in which we see floating rates most often are in mortgage interest rates, currency exchange rates, and bond yields. When an individual takes a mortgage loan on a property, he needs to decide whether a fixed rate or a floating rate -- also called an adjustable rate -- is the most desirable. If interest rates are comparatively high at the time of the loan, the individual would most likely benefit from a floating rate, because as interest rates fell to historically normal or low levels, the interest rate on the loan would decrease. This would then result in the borrower paying less money in interest over the duration of the loan.
Currency exchange rates are subject to market fluctuations as well. Exchange rates as such are unrelated to interest rates, but rather refer to the amount that one currency is worth, in terms of another currency. When a currency’s value is allowed to fluctuate according to market conditions, then that currency is said to have a floating rate, or a floating exchange rate. For instance, one Euro may be worth $1.30 USD (U.S. Dollars) at a given time, and several weeks from that time, its value might have decreased to $1.24 USD or increased to $1.39 USD, or any other value. That is because, in this example, there exists a floating exchange rate between the U.S. Dollar and the Euro.
Many economists believe that floating exchange rates are more beneficial than fixed exchange rates, because they reduce the worldwide impact of economic shocks and business cycles. Fixed exchange rates can be preferable in certain situations when greater economic certainty and stability are needed, although this strategy can also lead to unintended negative results.
In the financial markets, bonds can have a floating rate of interest, and these are called floating rate notes (FRNs). FRNs pay out interest every three months in most cases. The rate of interest changes and is recalculated for every three-month period. The interest paid by FRNs consists of a “reference rate,” which is a floating rate, plus a “spread,” which is a rate that remains constant. From the perspective of the investor, FRNs can offer larger yields when compared to other strategies of investing in bonds, as well as reducing transaction costs to the investor.