How Currency Exchange Rates Work

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.

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