What Is an Exchange Rate?
An exchange rate is the value of a nation's currency when it is traded for another currency. The relative strength or weakness of a nation's currency has a strong impact on its trade with other nations, on its tourism industry, and on the prices its consumers pay for imports.
Exchange rates are always viewed in relation to the exchange rate of another currency. For example, the exchange rate from U.S. dollars to euros was 1.07 at the end of June 2024. That means one euro could be exchanged for $1.07.
Key Takeaways
- An exchange rate is the rate at which one currency can be exchanged for another currency.
- Most exchange rates are defined as floating. Their values rise or fall based on supply and demand in the foreign exchange market.
- Some exchange rates are pegged or fixed to the value of a specific country's currency.
- Movements in a nation's exchange rate change the real cost of the supplies that are purchased from abroad, the cost of imports that its consumers buy, and the level of demand for the nation's products overseas.
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Understanding Exchange Rates
The exchange rate between any two currencies is commonly determined by interest rates, economic activity, gross domestic product, and the unemployment rate in each of the countries.
Commonly called market exchange rates, currency prices are set in the global marketplace where financial institutions, money managers, and speculators trade currencies around the clock. This is called the forex or f/x market, although the market has no physical presence and no owner. Changes in rates can occur hourly or daily with small changes or in large incremental shifts.
An exchange rate is commonly quoted using an acronym for the national currency it represents. "USD" represents the U.S. dollar. "EUR" represents the euro.It would be EUR/USD if you were quoting the currency pair for the dollar and the euro.
An exchange of U.S. Dollars to Japanese yen is labeled as USD/JPY. An exchange rate of 100 means that one dollar equals 100 yen.
How Exchange Rates Fluctuate
Exchange rates can be free-floating or fixed. A free-floating exchange rate rises and falls due to changes in the foreign exchange market.A fixed exchange rate is pegged to the value of another currency. The Hong Kong dollar is pegged to the U.S. dollar in a range of 7.75 to 7.85, so the value of the Hong Kong dollar to the U.S. dollar will remain within this range.
Exchange rates have a spot rate or cash value that's the current market value. They may also have a forward value that's based on expectations for the currency to rise or fall versus its spot price.
Forward rate values fluctuate due to changes in expectations for future interest rates in one country versus another. Traders may buy the dollar versus the euro if they speculate that the eurozone will ease monetary policy versus the U.S., causing a downward trend in the value of the euro.
Exchange Rate Examples
A traveler to Germany from the U.S. wants $200 for the equivalent amount of euros on arrival in Germany. The sell rate is the rate at which a traveler sells foreign currency in exchange for local currency. The buy rate is the rate at which one buys foreign currency back from travelers to exchange it for local currency.
If the current exchange rate is 1.05, $200 will net €190.48 in return. In this case, the equation is: dollars ÷ exchange rate = euro:
$200 ÷ 1.05 = €190.48
Suppose €66 is remaining after the trip. The change from euros to dollars will be $67.32 if the exchange rate has dropped to 1.02:
€66 x 1.02 = $67.32
The Japanese yen is calculated differently. The dollar is placed in front of the yen in this case, as in USD/JPY. The equation for USD/JPY is dollars x exchange rate = yen.
A traveler to Japan would get¥11,000 if they want to convert $100 into yen and the exchange rate is 110. Convert the yen back into dollars by dividing the amount of the currency by the exchange rate:
$100 x 110 = ¥11,000.00
-or-
¥11,000.00/110= $100
Note that none of these travelers will be getting the market price when they exchange currency. The bank or currency exchange store that they do business with will add its fee to the transaction.
How Do Exchange Rates Affect the Supply and Demand of Goods?
Changes in exchange rates affect businesses by increasing or decreasing the cost of supplies and finished products that are purchased from another country. It changes, for better or worse, the demand abroad for their exports and the domestic demand for imports. Significant changes in a currency rate can encourage or discourage foreign tourism and investment in a country.
What Is the Forex?
The forex market, also known as the f/x, is an over-the-counter marketplace for trading currencies. This 24-hour market is responsible for trillions of dollars in daily trading activity as central banks, financial institutions, and speculators swap currencies to profit from their price movements or hedge against future price movements.
What Is a Restricted Currency?
A restricted currency has its value set by the government.
Some countries have restricted currencies, meaning they restrict the exchange of their currency to within their borders or establish both an onshore rate and an offshore rate.
China is an example. The Chinese government sets a midpoint value for the currency every day, allowing the yuan to trade in a band of 2% from this midpoint.
The Bottom Line
An exchange rate is the value of one currency in relation to the value of another currency. Most exchange rates are floating and rise or fall based on the supply and demand in the foreign exchange market but some are pegged to another country's currency or are fixed in value.
Fluctuations in a nation's exchange rate have an impact on the demand for its products abroad and the prices its consumers pay for imports.
