How do exchange rates work?
When you are abroad, you often have to exchange one currency for the other. You do the same when you actively trade in currencies or Forex. You basically convert one currency for another, hoping the currency you buy becomes more valuable. When you start investing in currencies, it is useful to understand how an exchange rate works. In this article, we will discuss what exchange rates are.
What is the exchange rate?
The exchange rate indicates the price of a currency. By looking at the exchange rate, you can see how much you have to pay for a dollar or a pound. The price of one currency is always displayed in the value of another currency.
How does the exchange rate work?
You cannot display the individual value of one currency. After all, the value of the euro in itself says nothing. When you go to a currency exchange, the exchange rate is therefore always displayed in relation to another currency. Consider, for example, the euro against the dollar (EUR/USD). The price of one currency in another currency is called a pair.
With Forex you always trade in pairs. A pair indicates the price of one currency in that of another. With EUR/USD, for example, you look at the number of dollars you can buy with one euro.
A currency pair is always represented as a ratio. When the rate of EUR/USD is 1.20, you get 1.20 dollars for one euro. This means that a laptop that costs 1000 euros costs 1200 dollars. Transaction costs are not considered in this example.
Base Currency & Quote Currency
The first currency in the ratio is called the base currency and always equals to one. The second number is called the quota currency, and this number indicates how much of the other currency you will get in return.
What is the price markup?
When you physically exchange money at the bank, you always pay an extra surcharge. Banks are commercial institutions and they therefore focus on making money. To be able to offer foreign currencies, they must hold a stock of all the different currencies. They then run the risk that these currencies will depreciate. By adding a markup, they can protect themselves against those risks. Of course, they have to ask for extra money to make it possible to operate profitably as well.
You can see how much the markup is by looking at how much the price deviates from the mid-market rate. This rate is also referred to as the average market rate, mid-market rate, or interbank exchange rate. This is the rate between the price that the bank offers for buying the currency, and the price the bank asks for selling the currency.
If you want to make money trading currencies, you shouldn’t do it physically. Due to the high exchange rate surcharge, it is almost impossible to make money in this way. If you want to make money with price fluctuations, it is best to trade Forex using a broker. Nowadays, this is done entirely via the internet. In our guide ‘investing in Forex’ you can read everything you need to know:
Some sample calculations with exchange rates
Do you still find exchange rates confusing? Using two small examples, we show how exchange rates work in practice.
In the first example, an exchange rate of EUR/USD 1.10 applies. This means that for one euro you receive one dollar and ten cents. You have 1000 euros and you want to exchange this for dollars. You will then receive 1100 dollars.
In the second example, there is an exchange rate of EUR/JPY 120. This means that for one euro you will receive 120 Japanese yen. You decide to exchange 1000 euros for the Japanese yen. In this case, you will receive 12,000 Japanese Yen.
Making money with the exchange rate
You can make money with the exchange rate. You do this by buying a currency that increases in value.
In this example, you expect the dollar to increase in value in relation to the euro. Currently, the exchange rate is EUR/USD 1.1. You buy dollars for 1000 euros. After exchanging the euros, you would receive 1100 dollars.
Subsequently, the value of the dollar rises. This causes the exchange rate for EUR/USD to drop to 1. You are now exchanging your 1100 dollars for euros again. In this case you receive €1100 back. You made a profit of 100 euro on this trade.
Via the internet, you can take advantage of the smallest price fluctuations at lightning speed. Do you want to know how this works? In our article about investing in foreign currencies you learn everything you need to know:
What type of exchange rates exist?
There are two types of exchange rates: flexible and fixed exchange rates. Flexible exchange rates fluctuate constantly, while fixed exchange rates hardly ever change.
Flexible exchange rates
Flexible exchange rates fluctuate constantly due to the interplay of supply and demand. The government and the Central Bank do not try to keep the exchange rate at a fixed value. The policy of the government can influence the price, but the exchange rates can move freely.
Fixed exchange rate
In some cases, governments want to keep the currency at a fixed value through the Central Banks. They do this by holding dollar reserves. Selling dollars and buying their currency decreases the supply of their currency. As a result, their currency will increase in value. This allows governments to manipulate their exchange rate whenever they wish. An example of such a fixed exchange rate is the Saudi Arabian riyal.
How does the price of a currency move?
As the price line on a chart rises, the base currency increases in value and the quote currency decreases in value. With EUR/USD this means that the value of the euro increases against the dollar. This does not mean that the euro will increase in value against all currencies. The euro could lose value to the pound simultaneously.
When the price line decreases, the base currency decreases in value, and the quote currency increases in value. You would receive fewer dollars for every euro you exchange. Keep in mind that the fall of EUR/USD does not necessarily mean that EUR/GBP also falls, the opposite may be the case!
What makes the price move?
The exchange rate of Forex is entirely influenced by the interplay of supply and demand. The exchange rate for currencies is therefore not much different from the prices of shares on the stock market. When the supply of a particular currency increases, the value of that currency decreases. When the demand for a particular currency increases, the value of that currency increases.
What factors influence the exchange rate?
The value of a currency is determined by the interplay of supply and demand. On larger scales, these factors play an important role in a currency’s exchange rate.
The economic situation in the region
Economic prosperity in a region often leads to a rise in the value of a currency. For example, when the American economy is doing well, more products are bought. People do this in the local currency and thus have to buy dollars. This allows the dollar to increase in value against, for example, the euro.
Interest rates also have a major impact on the exchange rate. When trading Forex, it is important to stay alert with Central Bank announcements about interest rates. When interest rates rise, demand for the currency tends to increase. When the ECB (European Central Bank) increases interest rates, there is a good chance that the euro will increase in value against the dollar, for example.
Supply of money
The supply of a currency also influences the exchange rate. When a Central Bank prints a lot of money, the supply increases. This can cause the price to fall. If there is too much money being printed, this can even lead to inflation.
The exchange rate is therefore 100% related to developments on the supply and demand side of the market. If you want to invest successfully in Forex, you will have to analyse the forces behind the supply and demand.
Using with pips with Forex
In the vast majority of currency pairs, a pip is the fourth number after the decimal point. When you notice that the EUR/GBP exchange rate is 1.1234, the fourth number or 0.0004 is the current pip value. If the price rises to 1.1235 the price has moved by one pip. When the price rises to 1.1244, the price rises by 10 pips.
The big exception to this rule is the Japanese yen. In Japanese yen ratios, the second number after the decimal point is the number that indicates the pip value. At a rate of EUR/JPY 123.86, 0.01 would be one pip value. When the exchange rate of EUR/JPY increases to 124, this would indicate an increase of 14 pips.
Pips are used in Forex to easily compare different profits and losses. You can then compare the results of Forex traders objectively. Do you want to know more about pips? In our article about pips you read everything you need to know:
Naturally, you want to make a profit when trading Forex. You do this by correctly predicting the future price developments. An increase of a cent can already lead to a good result. This is because with Forex you trade with larger amounts of money. You trade in Forex by using CFDs which allows you to apply leverage. This makes it possible to open a large position on the exchange rate with a smaller amount.
With Forex, you can both buy (go long) and sell (short). When you open a long position, you make money when the price rises. When you open a short position you earn money when the price falls.
At the broker, you often have a buy (ask) and sell (bid) price. There is a difference between these two prices, the so-called spread. The spread forms the transaction cost of the position you open and is the broker’s source of income.
Do you want to know where you can trade in Forex against cheap rates? In our overview of best brokers you can discover the best party:
How does the exchange rate affect your daily life?
The exchange rate of the currency you use in your country has a major impact on your daily life. You notice this strongly when you travel to another country. When your home currency is strong, you get more value for your money. You notice this when you go on holiday in another country.
The exchange rate also has a significant, indirect effect. When your currency is worthless, foreign products become more expensive. This can reduce your purchasing power.
Test your knowledge!
- EUR/USD increases from 1.2176 to 1.2201, with how many pips does the rate increase?
- GBP/JPY dropped from 142 to 141.5, would you make money by going long or short?
- AUD/USD increase from 1.02679 to 1.02699, how many pips did the rate increase?
- EUR/AUD bid 1.27364 sell 1.27391, how high is the spread?
- EUR/USD 1.25, what is the USD/EUR exchange rate at the moment?
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When I was 16, I secretly bought my first stock. Since that ‘proud moment’ I have been managing trading.info for over 10 years. It is my goal to educate people about financial freedom. After my studies business administration and psychology, I decided to put all my time in developing this website. Since I love to travel, I work from all over the world. Click here to read more about trading.info! Don’t hesitate to leave a comment under this article.