Factors that influence currency exchange rates are important for various reasons. For countries, these factors can affect how one country trades with another. For individuals, these factors affect how much money one can get when exchanging one currency for another. Although it is not always easy to understand, track, or even anticipate these factors, it pays to know them, especially if you are interested in foreign currency. It is worth noting that these factors affect currency exchange rates at a macroeconomic level, meaning they affect global currency exchange rates and not local exchange rates.
In this article, we highlight nine factors that affect currency exchange rates, starting with the most significant factor – inflation.
1. Inflation
Inflation is the relative purchasing power of a currency compared to other currencies. For example, it might cost one unit of currency to buy an apple in one country but cost a thousand units of a different currency to buy the same apple in a country with higher inflation. Such differentials in inflation are the foundation of why different currencies have different purchasing powers and hence different currency rates. As such, countries with low inflation typically have stronger currencies compared to those with higher inflation rates.
2. Interest Rates
Interest rates are tightly tied to inflation and exchange rates. Different country’s central banks use interest rates to modulate inflation within the country. For example, establishing higher interest rates attracts foreign capital, which bolsters the local currency rates. However, if these rates remain too high for too long, inflation can start to creep up, resulting in a devalued currency. As such, central bankers must consistently adjust interest rates to balance benefits and drawbacks.
3. Public Debt
Most countries finance their budgets using large-scale deficit financing. In other words, they borrow to finance economic growth. If this government debt outpaces economic growth, it can drive up inflation by deterring foreign investment from entering the country, two factors that can devalue a currency. In some cases, a government might print money to finance debt, which can also drive up inflation.
4. Political Stability
A politically stable country attracts more foreign investment, which helps prop up the currency rate. The opposite is also true – poor political stability devalues a country’s currency exchange rate. Political stability also affects local economic drivers and financial policies, two things that can have long term effects on a currency’s exchange rate. Invariably, countries with more robust political stability like Switzerland have stronger and higher valued currencies.
5. Economic Health
Economic health or performance is another way exchange rates are determined. For example, a country with low unemployment rates means its citizens have more money to spend, which helps establish a more robust economy. With a stronger economy, the country attracts more foreign investment, which in turn helps lower inflation and drive up the country’s currency exchange rate. It is worth noting here that economic health is more of a catch-all term that encompasses multiple other drivers like interest rates, inflation, and balance of trade.
6. Balance of Trade
Balance of trade, or terms of trade, is the relative difference between a country’s imports and exports. For example, if a country has a positive balance of trade, it means that its exports exceed its imports. In such a case, the inflow of foreign currency is higher than the outflow. When this happens, a country’s foreign exchange reserves grow, helping it lower interest rates, which stimulates economic growth and bolsters the local currency exchange rate.
7. Current Account Deficit
The current account deficit is closely related to the balance of trade. In this scenario, a country’s balance of trade is compared to those of its trading partners. If a country’s current account deficit is higher than that of a trading partner, this can weaken its currency relative to that country’s currency. As such, countries that have positive or low current account deficits tend to have stronger currencies than those with high deficits.
8. Confidence/ Speculation
Sometimes, currencies are affected by the confidence (or lack thereof) traders have in a currency. Currency changes from speculation tend to be irrational, abrupt, and short-lived. For example, traders may devalue a currency based on an election outcome, especially if the result is perceived as unfavorable for trade or economic growth. In other cases, traders may be bullish on a currency because of economic news, which may buoy the currency, even if the economic news itself did not affect the currency fundamentals.
9. Government Intervention
Governments have a collection of tools at their disposal through which they can manipulate their local exchange rate. Primarily, central banks are known to adjust interest rates, buy foreign currency, influence local lending rates, print money, and use other tools to modulate currency exchange rates. The primary objective of manipulating these factors is to ensure favorable conditions for a stable currency exchange rate, cheaper credit, more jobs, and high economic growth.
You have probably heard of people making money on the foreign currency exchange market. They invest small amounts and reap significant returns. If you are like many people, you may be wondering whether you can start trading and make money in forex. The answer is yes. Anyone can learn a forex trading strategy, open a forex account, and start buying and selling currency. However, before you rush off to open your trading account, it pays to understand how the forex market works and how forex traders make money. This article covers three primary areas in forex trading: what it is, standard terms, and how to get started.
Explaining Buying and Selling Currency
The foreign currency exchange or forex market is a massive network of retail and wholesale forex traders, each trying to benefit from the market’s various movements. Within the forex market, there are currency pairs. Each pair is made up of a base currency and quote currency. Some examples are EUR/USD and JPY/USD. When trading a currency pair, a trader buys a currency pair hoping that it will either go up or down, depending on whether they are long or short.
To access the forex market, you need a trading account, which is provided by forex brokers. With a trading account, you can open either a demo account, which has simulated money, or a live account, which you must fund. While currency trading can be lucrative, losing money is extremely easy, as explained in the leverage section below. With the basics out of the way, what is the difference between passive investing and active trading?
Passive Investing vs. Active Trading
Some foreign currency exchange traders approach forex as a passive longer-term investment like commodities and futures, which are governed by the commodity futures trading commission (CFTC). While this is an option, such traders hardly make the returns that active traders make. Active traders, also called day traders, usually open and close positions within one or a few days. Their primary objective is to capitalize on the volatility (changes) currency pairs have throughout the day. If you want to make money as a forex trader, you must learn how to day trade rather than become a passive investor.
Foreign Exchange Trading Terms to Familiarize Yourself With
Forex trading has several essential terms that outline how the system works. Here, we describe the top four terms:
Forex Quote
Forex currencies are always quoted as pairs like EUR/USD, GBP/USD, or CAD/USD. They are quoted this way because each foreign currency exchange transaction is a simultaneous buy and sell of each respective currency in the pair. In the pair, the currency to the left is the base currency, while the one to the right is the quote currency.
Long and Short
All orders placed in the forex market are either buy orders or sell orders. If you choose to buy, you hope that the market will go up so you can sell higher than you purchased, a position called going long. In contrast, when you put a sell order, you hope the market will go down so that you can repurchase your currency at a lower price. This is called going short.
Bid, Ask and Spread
Forex quotes are represented as either a bid or an ask. The bid price is the best price you can sell on the market, while the ask (or offer) price is the best price you can buy from the market. The difference between these two prices is called the spread and is set by the broker as a commission for every purchase and sell order.
Leverage and Risk Management
Leverage is the amount of money the broker is willing to “lend” you for each trade. For example, a leverage of 1:200 means the broker will lend you two hundred dollars for every dollar you commit to a trade. Risk management is the practice of limiting leverage and the number of trades plus using stop-loss orders to prevent massive losses.
Creating a Forex Trading Strategy
To make money out of foreign currency exchange, you need a trading strategy. There are standard trading strategies, but in practice, there are probably as many trading strategies as forex traders. That is because no two traders trade precisely the same. However, all traders use the following three building blocks:
Technical Analysis
Technical analysis is the study of price movement. The basic premise here is that historical price movements are predictive of future price movements. Therefore, by studying these cyclic price movements, traders can estimate where the price will go next. It is important to note that this approach is not about predicting price movement but estimating the probability of price movement.
Fundamental Analysis
Fundamental analysis is the study of social, political, and economic data and how it affects price movement. Since these three factors underpin supply and demand, closely monitoring them can tell a trader whether supply or demand forces are in control. Although you do not need a degree in economics or political science to undertake fundamental analysis, you will need to understand how various social, political, and economic drivers influence price movement.
Sentiment Analysis
Sentiment analysis is the study of how other traders are perceiving a currency pair. Are they optimistic about it (bullish) and willing to buy, or pessimistic (bearish) and more predisposed to sell? Sentiment analysis determines whether the bulls are in control or the bears, with each scenario pushing the price one way or the other.
Next Steps
What should you do next to start making some money on buying and selling foreign currency? Here are three next steps to consider:
1. Find a Reputable Broker
Reputable forex brokers are regulated in at least two countries, have adequate staff to handle customer queries, and are well-capitalized to absorb market shocks. You also want to find forex brokers with low spreads and who offer relatively high leverage, especially if you’re going to start with a small sum of money.
2. Choose a Trading Platform
A trading platform is what you will use to connect to the forex market. While there are many options on the market, not all perform at the same level. Download a few versions, test them on your computer and pick the one that performs best and has the features you need most.
3. Practice, Learn, Repeat
Open a demo account and practice your trading strategy. Since you are using simulated money, you can afford to lose money without feeling the pinch. It is best to use a demo account until you establish a system of consecutive successful trades.
4. Open a Live Account
Once you have a successful trading strategy, open a live account, fund it, and start trading. With proper planning and a bit of luck, you will be well on your way to making money out of foreign currency exchange trading.
Buying foreign exchange currency is sometimes necessary, especially when traveling or sending money to someone in a different country. If you are traveling, you might use your debit card to make purchases, but it is always good to have some local currency. When you do, you can quickly pay for things like transportation, street food, or make other informal payments. A helpful rule of thumb is to have around fifty dollars’ worth of local currency for contingency purposes. In this case, you will need to exchange your local money, for example, your Canadian dollars, to your destination country’s foreign exchange currency.
In this article, we break down all you need to know about where to buy foreign currency both locally and when abroad.
Where to Exchange Foreign Currency Locally
It is wise to plan and exchange your Canadian dollars for your destination country’s local currency. In this case, you have several options to pick from:
CanAm Currency Exchange
CanAm Currency Exchange offers some of the best currency exchange rates in Windsor. With exchange rates up to 2.75% better than interbank rates, buying foreign currency at CanAm saves you quite a bit of money. CanAm Currency Exchange offers both electronic funds transfers across Canada and in-person transactions at its outlet in 3234 Dougall Ave, Windsor, ON N9E 1S6.
Post Offices, Bank or Credit Union
Your local financial institution or post offices are your best bet when it comes to exchanging foreign currency at a reasonable rate. In Canada, the currency conversion rate in these institutions is based on indicators set by the Bank of Canada. When buying foreign currency, you can either visit a branch and purchase the currency, or make an order online, which may come with some charges.
Online Foreign Exchange Provider
You can also exchange your money using an online currency exchange service provider. They offer both in-person pick-up or delivery. Their rates differ from those of a bank but are slightly better than a traditional forex bureau. If you request a more substantial amount of foreign currency, they may give you a more favorable exchange rate or waive your delivery charges.
Traditional Forex Bureau
Traditional forex bureaus are typically strategically located at places like the airport, popular shopping malls, and other high-foot-traffic areas. While they are easily accessible, you may not get the best exchange rate. Traditional forex bureaus are an excellent option if you cannot access any of the other options above.
Where to Exchange Foreign Currency When Travelling
If you cannot buy foreign exchange currency before you travel, do not worry, you have some options once you arrive at your destination.
Here they are, ranked from the best exchange rate to the worst:
Your Bank’s ATM Network
Using your bank’s ATM network to buy foreign currency can be convenient, safe, and fast. Depending on your bank’s policies, you can withdraw cash in the local currency straight from your checking account. The drawback of this method is that you have no option to negotiate the rate, and you will have to pay ATM fees for each withdrawal.
Foreign Bank Counters or ATMs
You can also buy foreign currency from a local financial institution. Walk into a branch and purchase local currency or use a local ATM that supports your card brand. Keep in mind that this method relies on local exchange rates, which may be influenced by factors like local interest rates and inflation.
Local Forex Bureaus, Hotels and Stores
If you must buy foreign exchange, you can do so at a forex bureau, hotel, or store. Since they usually offer vastly different rates from banks, you should only exchange the least amount you need.
Remember The Three Golden Rules of Exchanging Foreign Currency
Now you know where to buy foreign exchange currency, but there are some rules of thumb you should always keep in mind. They are:
1. Avoid exchanging foreign currency at the airport, hotel, or other tourist centers.
We have touched on this earlier in the article. The reason you should avoid these places is that they have high exchange rates. For example, if your bank adds five basis points to the exchange rate, these places may add up to twenty basis points. They do this because they anticipate that foreigners and tourists urgently need foreign currency. To avoid this, either exchange your money before traveling or only exchange a minimal amount and exchange a more substantial amount when you have access to a bank or ATM.
2. Always compare exchange rates beforehand.
Understanding what different exchange rates mean is essential in the foreign exchange process. If you are traveling from Canada to France, for instance, understand how the currency pair trades against each other. Doing so will help you understand the various quotes you will get when you exchange your money.
3. Cards and ATMs offer convenience at a cost.
Using your debit or credit card to buy foreign currency is easy and convenient but can come at a steep cost. Before using this method, always inquire from your bank what charges you will incur during currency conversion. The same goes for ATMs. ATM fees can mount if you are continually withdrawing foreign currency. If you must use your card or an ATM, withdrawing in batches is your best option.
In Summary
If you were wondering where you should exchange foreign currency, now you have some options. Once you understand the basics, it should be easy to buy foreign exchange currency, whether locally or when traveling. Whichever option you pick, always remember that you are in control of how much foreign currency you get for your money. If you are not happy with an exchange rate in one place, you are always free to visit a different place and request a better exchange rate.
Finding the best ways to send money abroad may help you periodically like when you travel or influence your daily life if you are a freelancer. Understanding factors like money transfers fees, currency exchange rates, and transfer timelines can mean the difference between getting most of your money at the end of the transfer, or forfeiting a considerable chunk. In this article, we cover the options you have for sending money overseas and tell you what the pros and cons of each option are.
Factors to Consider First Before Transferring Money Overseas
Choosing the best ways for sending money overseas relies on what you need most from the transfer. For example, if you need speed, you may have to pay more for your transfer. Similarly, if you want the best currency exchange rate, you may have to wait a bit longer to get the money. Picking the best way to send money abroad involves a tradeoff of several factors, including:
- Whether you are sending one currency and receiving a different currency or sending and receiving the same currency
- Currency exchange rates
- The amounts of money you are sending (smaller amounts or larger amounts)
- How fast you want the money sent and received
- The sending country and receiving money country
- The frequency of sending
- Origination of funds (cash, bank account, business proceeds, Bitcoin, or credit card)
- Transfer fees and how this will affect the total amount received or sent
It is important to note that no one money transferring service can tick all the boxes at once. Some will allow you to send money faster, but at a higher cost, while others will give you better rates for larger amounts and high transfer fees for smaller amounts.
Online Payment Providers
PayPal
PayPal allows you to send money to one hundred and ninety countries in up to twenty different currencies. To complete the transfer, all you need is the recipient’s phone number or email, although they will need to create a PayPal account to access the funds. PayPal is a great money transfers option if you are sending smaller amounts (less than $500) and if the other person also has a PayPal account and can withdraw to their bank account or mobile wallets.
Pros
PayPal is very transparent when it comes to fees and exchange rates. Also, all you need is a phone number or email address to send money, making sending money as easy as sending an email or text message.
Cons
PayPal has opaque terms of service, and they can freeze funds or close your account with no notice. PayPal is also quite expensive when transferring large sums above $2,000, costing up to 4% of the total amount sent.
Google Pay
Google Pay works like PayPal. All you need is an email or phone number to send someone money. Google Pay charges no fees to send money, although you will incur a 2.9% processing fee. Google Pay is a good option if you are sending mid-range amounts (the transfer limit is $10,000), and if the recipient has access to Google Pay withdrawal methods (debit card or bank account).
Pros
Google Pay charges no transfer fees, which makes it a cheaper option than PayPal. The service also charges no fees to withdraw money either to a debit card or to your bank account.
Cons
Google Pay money transfer services are only available in the United States, UK, and India. This limited coverage makes it a poor option if you want to send money to other countries besides these.
Other Online Payment Providers
- Xoom
- Skrill
- Neteller
- Amazon Pay
Money Transfer Service Providers
Western Union
Western Union has over four thousand locations worldwide and offers options to send money internationally via their website, a physical location, your bank, or a mobile app. Recipients can get cash in their mobile wallets, bank account, or pick up at a physical location. Western Union money transfers are best for sending money fast and allowing the recipient to access the funds conveniently.
Pros
You can choose to send money and have it immediately available to the recipient. Also, recipients do not have to open an account or even have a bank account, which makes it easy, especially when sending to individuals moving from country to country.
Cons
For faster transfers, Western Union fees and currency exchange rates can be high. Sending money is also more complicated since you must input multiple identity details of the recipient.
TransferWise
TransferWise is a hybrid between a traditional money transfers service and an online payment provider. They differentiate themselves by offering actual currency exchange rates and allowing you to open a virtual bank account from which to send and receive money from other international bank accounts. TransferWise is an excellent option for freelancers and individuals who work with foreign contractors due to the ability to wire money directly from bank account to bank account.
Pros
You get the actual currency exchange rate when sending money, and all you pay is a standard transfer fee. The service offers virtual multi-currency bank accounts, allowing you to send or receive money using same-currency accounts.
Cons
Money transfers are not instantaneous, and you may be subject to lower transaction limits if you do not have a business account.
Other Money Transfer Service Providers
- MoneyGram
- WorldRemit
- Travelex
- Remitly
- Ria
Banks
Wire Transfer
Sending a wire transfer from one bank to another is another way you can send money abroad. In this method, both parties must have a bank account, even if in different banks. Wire transfers typically take between one and five business days to complete. Wire transfer is a good option if you are making business payments or transferring large amounts that you need available in the other bank account.
Pros
Bank wire transfers are preferable when sending large sums because of the increased security. The money is also deposited in a bank account, which makes it easy to spend using other payment methods like PayPal, Google Pay, and others.
Cons
Bank wire transfers have notoriously high currency exchange rates. While fees are typically fixed, you can expect a currency exchange rate that is up to 10% of the total amount you are sending.
Intrabank Money Transfers
If your bank has a branch in the recipient’s country, you can easily perform an intrabank transfer from your local bank account to a bank account held in the foreign bank. Intrabank transfers are a great option if you have bank accounts in banks that have an extensive international footprint like HSBC, Barclays, and Citibank.
Pros
Some banks offer free intrabank transfers, even if the transfer is from one country to another. Additionally, you can open same-currency accounts in both countries and make significant savings on currency exchange rates.
Cons
Not all banks have a strong international presence. Moreover, if you are only sending money periodically or when traveling, it makes little sense to open and operate a bank account in a foreign country.
Other Bank Options
- Money orders
- Traveler’s checks
- Banker’s checks
- Debit cards
- Credit cards
Currency Exchange Brokers
Currency exchange brokers specialize in exchanging your currency and sending the funds to a recipient bank account. One standout feature of this service is that you get a live exchange rate quote. That is, they give you a quote that if you do not like, you can reject and wait for a better rate. Currency exchange brokers are a great option if you want enhanced control over the currency exchange rate you get.
Pros
The service offers live exchange rate quotes, allowing you to get the best current rate for your transfer. Recipients get money in any country in which they have a bank account.
Cons
Currency exchange brokers offer a limited range of services, with transfers limited only to bank-to-bank transfers. You also need a working knowledge of currency exchange rates to pick the best rate.
Currency Exchange Broker Examples
- OFX
- WorldFirst
- XE
- TorFX
- Currencies Direct
Cryptocurrency
Cryptocurrency is a new entrant in the international money transfer arena. Sending money abroad via cryptocurrency involves both parties having a cryptocurrency wallet. To send money, you will need to open an account with a crypto exchange like Coinbase or Kraken, fund your account, purchase cryptocurrency, then send the funds to the recipient’s wallet. Fees associated with such transfers are typically low, and transfers conclude within minutes.
Pros
Sending money is extremely cheap and relatively fast. You can also benefit from changes in cryptocurrency prices since they tend to have high volatility.
Cons
You need to be tech-savvy to send money through cryptocurrencies. Some banks have blacklisted cryptos, so you may not be able to fund your crypto account from your bank account or withdraw money from a crypto wallet.
Cryptocurrency Mobile Wallets Service Providers
- Coinbase
- Kraken
- Binance
Final Words
As you can see, there are many options for sending money abroad. Choosing the best ways to send money abroad depends on your priorities and the factors listed at the start of this article. Our advice is that you weigh your options and pick the one that meets your most urgent needs, whether that is the speed of transfer, low transfer fees, excellent exchange rates, or ease of collection.
Foreign Exchange Risk Defined
A foreign currency exchange risk is the loss that can occur between international financial transactions due to currency fluctuations.
This is commonly mentioned as a fx risk, currency risk or exchange-rate risk.
Another version of this is a jurisdiction risk in the form of a foreign exchange risk.
A Jurisdiction risk is a risk that arises when someone operates in a foreign jurisdiction.
This risk can occur when you do business in another country, especially when an investor is exposed to unexpected changes in the laws of that certain country.
These are known as foreign exchange exposures.
Everything You Need to Know
When we try to understand foreign exchange risk, we are looking at a risk that occurs when a company decides to engage in a financial transaction that is conducted in a currency that is different from the currency that that company is based on.
This means that the value of the money fluctuates, and there is a risk of the value appreciating or depreciating in its base value.
This can be most commonly felt by investors who trade on international markets or businesses involved with import or export of products or services throughout more than one country at any period of time.
Types of Foreign Currency Exchange Risks
There four types of foreign exchange currency risks.
Transaction risk, translation risk, contingent risk and economic risk.
Transaction Risk
Transaction risk occurs when a company buys a product from a company that is geographically in a different location.
This means that the price has an advantage in the country which sells the product.
In other words, the company which buys the product pays more for it than the price defined in the company which sells the product.
Contingent Risk
This risk can occur when a company bids for foreign projects, negotiates other contracts, or handles direct foreign investments.
This can happen due to the potential of a firm to face a transactional or economic foreign-exchange risk contingent on the outcome of the contract.
In other terms, when a company waits for a project bid to be accepted by a foreign business, which when accepted will result in an immediate receivable, during the waiting period the company faces a contingent risk from the uncertainty of whether or not the receivable will acute.
Economic Risk
Economic risk occurs when a company’s market value is shifted due to currency fluctuations.
This can affect the company’s market share when measured by its competitors and the firm’s future cash flow.
There is also the possibility that macroeconomic conditions will influence an investment in a foreign country, such as exchange rates, interest rates, government regulations and political stability within that specific country.
When a project is being financed, a company’s operating cost, debt obligations and the prediction of economic unsustainable circumstances can be calculated in order to produce adequate revenue that covers these risks, in other words, this is known as risk management and can lead to the calculation of profit margins.
Exchange Rate Risk Defined
The exchange rate risk is an unavoidable risk which involves foreign investment and can be mitigated through hedging methods.
Keep in mind that this risk is, as mentioned above, unavoidable, but it can be mitigated.
This risk occurs due to the fluctuation between an investor’s default country’s currency and the currency in the foreign country he is investing in.
These risks can be mitigated by using a hedged exchange-traded fund or through different investment paths such as futures or options, and there are a lot of hedging strategies investors tend to use.
How It Works
The US dollar can constantly surge, and the risk can erode returns from overseas investments.
This means that any foreign investor who makes U.S. investments can perform well because of the depreciation of the local currency against the USD, and it can lead to better returns.
When you decide to make a foreign investment, you need to leave the exchange rate risk unhedged when the local currency is depreciating against the foreign-investment currency.
You can hedge it when the local currency is appreciating against the foreign-investment currency.
Currency exchange rates are commonplace for travelers, bankers, international investors, and businesses with global trade. For people not involved in these fields, an exchange rate may seem a bit confusing. Before we look at how to read and calculate currency exchange rates, it is necessary first to define what it is.
An exchange rate is the amount of one currency you need to buy another currency. For example, if you have 100 US dollars and want to buy Euros, how many Euros will you get for your money? Looking at the Euro and USD exchange rate will give you this information.
But which exchange rate should you consider? EUR/USD or USD/EUR?
How to Read Exchange Rates
Exchange rates are written as currency pairs.
For example:
- USD/EUR (US Dollar/European Euro)
- USD/CAD (US Dollar/Canadian Dollar)
- USD/AUD (US Dollar/Australian Dollar)
- USD/JPY (US Dollar/Japanese Yen)
- USD/GBP (US Dollar/British Pound)
In these pairs, the first currency (USD in this case) is called the base currency and the second currency (in this case Euro, Canadian Dollar, etc.) is called the term currency or quote currency.
Let’s say you see a currency exchange rate saying USD/EUR is 0.88, what does this mean?
It means that you need 0.88 Euros to buy 1 US dollar.
Going back to the currency pair, the rate is read as how much of the second currency (quote currency) is needed to buy one unit of the first currency (base currency). In this case, to reiterate, you need 0.88 Euros to buy 1 US dollar.
What if you see a rate written EUR/USD?
You can apply the same process to read this currency pair: how many US dollars do you need to buy 1 Euro. In this case, the exchange rate is 1.13. That is, you need 1.13 US dollars to buy 1 Euro.
You can use the same method to determine the value of all the other pairs:
- USD/CAD (The number of Canadian dollars you need to buy 1 US Dollar)
- USD/AUD (The number of Australian dollars you need to buy 1 US Dollar)
- USD/JPY (The number of Japanese Yen you need to buy 1 US Dollar)
- USD/GBP (The number of British Pounds you need to buy 1 US Dollar)
Now that you know how to read a currency exchange rate let us now turn to how to calculate the exchange rate.
How to Calculate Exchange Rates
The best way to understand how to calculate an exchange rate is to use an example.
Let’s say you run a business in the United States that relies on international suppliers. One of your suppliers, who is in Australia, sent you a shipment worth $35,000 Australian Dollars. How many US dollars should you send them to cover the amount?
AUD/USD
In this case, should you look for the USD/AUD rate or the AUD/USD rate? It may sound confusing, but there is an easy way to approach it. Since your supplier wants to be paid in Australian Dollars, you need to buy that currency with your US dollars.
That means you need to find out how many US dollars you need to buy one Australian dollar. Since the Australian Dollar unit is one, then it is the base currency (i.e., the first currency in the pair).
Thus, you will write the pair as AUD/USD, which asks how many USD you need to buy one AUD.
Now go to a currency exchange quote provider online like XE.com and look for the AUD/USD exchange rate.
Currently, it is 0.7.
That means you need 0.7 USD dollars to buy 1 Australian dollar.
Now, multiply the amount you owe by 0.7
$35,000 x 0.7 =$ 24,500
You need $24,500 US dollars to purchase and send $35,000 Australian dollars.
Reversing the Calculation
What if you are the supplier and are owed $35,000 USD by an Australian business?
They would simply reverse the currency pair to USD/AUD (how many Australian dollars are needed to buy 1 US dollar)
In this case, they would need to spend AU$1.43 for every dollar they buy.
$35,000 x 1.43 = $50,000
They would need to spend AU$50,000 to buy and send you US$35,000
A Word on Spreads
When calculating currency exchange rates, it is essential to factor in spreads. Spreads are the extra margin (or percentage points) brokers add to each transaction. Spreads are the reason the rate your local banks quote you will always differ from what you see on the Internet. When calculating and negotiating exchange rates, always keep in mind that these spreads can be quite high and can influence how much of another currency you get for your money.
How Do Currency Exchange Rates Work?
Currency Exchange rates refer to the worth of your currency when converted to a foreign currency. There is no constant exchange rate due to the active trading that goes on with currencies. It is why the rate increases and decreases. Think of it like stock market trading or the sale of valuables. You’ll realize that there isn’t a static rate for them and it is the same with exchange rates.
You might think only people who import and export goods and services should care about exchange rates but that’s not the case. When you travel from one country to another, you’ll need to exchange currencies to the one in use in whatever country you find yourself in. Yet, when you exchange currencies, you’ll notice that you’ll either get more or less of the currency in the country you’re in. Let’s explore why.
Factors That Affect Exchange Rate
Different factors affect the exchange rate. Here are some of them:
Rate of inflation
Market inflation can affect currency exchange rates. A country with a higher inflation rate than the other will witness a depreciation in its currency’s value and vice versa. What this means is that if you try to exchange your currency to another one, you’ll likely get less of the currency you’re changing to because your country’s currency has been suppressed.
Political Stability
The political affairs of a country can affect its currency’s value. A country battling political instability can be a risky investment for foreign investors. It likely means that the foreign capital in the country will decrease over time, and the domestic currency’s value will depreciate.
Many countries in the world are going through and have been going through political instability for some time now. This has led to the currency severely being depreciated because of the lack of foreign investment. Foreign investors may stay away because of widespread corruption and the assumption of too much risk when investing in a politically unstable country.
Recession
A recession can have a big impact on a country’s currency. Generally, during a recession, inflation tends to fall and this may lead to an increase in demand for that country’s currency. However, in other instances, when a country falls into a recession, it’s usually a signal to other investors that economic conditions are weak in that country and their currency may ultimately suffer because of this.
Thus, recessions can sometimes have a beneficial or negative effect on a country’s currency.
Reading an Exchange Rate
An exchange rate is usually presented in pairs. You’ll have one currency paired with another one. What this means is the first currency in the pair is the base and the value should be $1. The next figure is how much of that currency it will take to purchase $1 of the base currency.
Here is an example of how to convert currencies: If the EUR/AUD currency pair is 1.56 (just an example), it only means that 1 Euro equals to 1.56 Australian Dollar. Therefore, it shows much AUD (second currency) is needed to buy a single unit of EUR (first currency).
To calculate how much first currency (EUR) you’ll need to purchase the second currency (AUD), you will use this formula: 1/exchange rate.
With the example provided above, it will be 1/1.56=0.6410. It means that it costs 0.6410 Euros to purchase 1 Australian Dollar.
How Exchange Rates Concern You
If you are a traveller going to another country that uses a different currency, exchange rate values concern you. For example, if you an American and the US Dollar is strong at the time of your travel, you’ll enjoy the luxury of purchasing more foreign currency and enjoying a relatively cheaper trip. If it’s the other way round, your journey becomes more expensive and you’ll get less foreign currency.
If you’re a person who does business by importing and exporting goods, exchange rates concern you, as well. If your currency has a higher value than the country you’re buying goods from, you’ll purchase more goods but if it’s lower, you should expect to pay more money for those goods.
Exchange Rate Changes
The foreign exchange market is always active. There is no period of inactivity because it is not time-bound. It operates 24 hours a day, including weekends. Therefore, exchange rates fluctuate based on events and trends.
How to Determine Currency Exchange Rates
Currency rates are deeply rooted in the laws of barter. It works based on supply and demand. A currency that is doing well will be more demanded than other currencies that aren’t particularly strong at the moment. The more demand a currency has, the higher it’s value will be and this will impact its price as well.
Since there is a limited supply of such currencies and a high demand for them, they are valued at high prices. Here’s an example: if the Canadian economy is soaring high, Australian investors might be interested in Canadian dollars. Since Canadian dollars has become the in-demand currency, the Australian investors would have to part with more Australian dollars to purchase Canadian dollars.
Conclusion
Currency exchange rates play a crucial role in the way everyday people live their lives. A favourable exchange rate will often get them more of the currency they are exchanging to. However, a less in-demand currency means they will have to use more of their home country’s currency to exchange for another foreign currency.
