What Is an Exchange Rate?
An exchange rate is the rate at which one currency will be exchanged for another currency. It affects trade and the movement of money between countries.
Exchange rates are impacted by both the domestic currency value and the foreign currency value. The exchange rate from U.S. Dollars to the Euro was 1.07 in April 2024. It took $1.07 to buy €1.
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. They'll rise or fall based on supply and demand in the market.
- Some exchange rates are pegged or fixed to the value of a specific country's currency.
- Exchange rate changes affect businesses by changing the cost of supplies that are purchased from a different country and by changing the demand for their products from overseas customers.
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Understanding Exchange Rates
The exchange rate between two currencies is commonly determined by the economic activity, market interest rates, gross domestic product, and unemployment rate in each of the countries. Commonly called market exchange rates, they're set in the global financial marketplace where banks and other financial institutions trade currencies around the clock based on these factors. 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.
It's USD/JPY or dollar to yen in the case of the Japanese yen. 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 can 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., resulting in a downward trend in the value of the euro.
Exchange Rate Examples
A traveler to Germany from the U.S. wants 200 USD worth of EUR when arriving 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
How Do Exchange Rates Affect the Supply and Demand of Goods?
Changes in exchange rates affect businesses by changing the cost of supplies that are purchased from a different country and by changing the demand for their products from overseas customers.
What Is the FOREX?
The forex market or foreign exchange market allows banks, funds, and individuals to buy, sell, or exchange currencies. The market operates 24 hours five days a week and is responsible for trillions of dollars in daily trading activity as traders look to profit by betting that a currency's value will either appreciate or depreciate against another currency.
What Is a Restricted Currency?
Exchange rates can differ within the same country. Some countries have restricted currencies, limiting their exchange to within the countries' borders and there's often an onshore rate and an offshore rate. A more favorable exchange rate can often be found within a country's borders versus outside its borders and a restricted currency has its value set by the government.
China is an example of a country that has this rate structure and a currency that's controlled by the government. The Chinese government sets a midpoint value for the currency every day, allowing the yuan to trade in a band of 2% from the midpoint.
The Bottom Line
An exchange rate is a rate at which one currency can be exchanged for another currency. Most exchange rates are floating and will rise or fall based on the supply and demand in the market but some are pegged or fixed to the value of a specific country's currency. Exchange rate changes affect businesses and the cost of supplies and demand for their products in the international marketplace.
