Exchange Rate

Exchange rate is the amount in which one currency is traded for another

    Author: Sid Arora
    Sid Arora
    Sid Arora
    Investment Banking | Hedge Fund | Private Equity

    Currently an investment analyst focused on the TMT sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

    Sid holds a BS from The Tepper School of Business at Carnegie Mellon.

    Reviewed By: Austin Anderson
    Austin Anderson
    Austin Anderson
    Consulting | Data Analysis

    Austin has been working with Ernst & Young for over four years, starting as a senior consultant before being promoted to a manager. At EY, he focuses on strategy, process and operations improvement, and business transformation consulting services focused on health provider, payer, and public health organizations. Austin specializes in the health industry but supports clients across multiple industries.

    Austin has a Bachelor of Science in Engineering and a Masters of Business Administration in Strategy, Management and Organization, both from the University of Michigan.

    Last Updated:January 4, 2024

    What is an Exchange Rate?

    An exchange rate is the amount in which one currency is traded for another. In other terms, when the amount in which someone is willing to sell their currency for another and the amount someone is willing to sell their currency for another match. This supply and demand match for a given currency decides the rate.

    These rates can be between any two currencies; as long as they are available in the market, there always is a rate between 2 currencies. Currencies like the U.S Dollar, Great British Pound, and the Euro are heavily traded on an hourly basis between investors and governments.

    Foreign trade heavily depends on these rates as they determine the value or purchasing power a foreign bill has compared to another. 

    For example, In April 2023, the rate from United States Dollars (USD) to Great British Pounds (GBP) was 1.24. This means that it would take $1.24 to trade for £1.

    This gives GBP more purchasing power since it’s worth more per unit. The government and investors heavily monitor these prices due to their presence in all economics. But purchasing power isn’t everything. 

    Key Takeaways

    • Exchange rates represent the value of one currency in terms of another and are determined by the supply and demand for those currencies in the market.
    • Exchange rates are crucial for international trade, travel, and investments, impacting the purchasing power of different currencies.
    • Factors affecting exchange rates include supply, demand, stability, balance of payments, interest rates, inflation, economic strength, and fiscal and monetary policies.
    • Exchange rate systems can be free-floating, managed, or fixed, each with varying levels of government intervention and control.

    Importance of Exchange Rates

    These rates permit all foreign trade. From a small grocery shop haul to an overseas car, all money flowing through countries must be swapped.

    Whenever you need to travel over borders and buy items from abroad, you need to swap your currency. For example, nobody in France will sell anything unless you pay Euros. 

    More importantly, governments and large corporations often purchase large sums of money to:

    1. Purchase goods from another country

    The most common use of overseas exchange is to buy goods from another country. A multitude of companies and even governments buy goods from other countries because of lower prices, faster production, trade deals, etc.

    These large-scale trades determine the majority of exchanges in the world. 

    2. Stabilization 

    In most cases, governments exchange their bills for U.S. dollars (USD). 

    As the most widely used bill, foreign entities commonly seek out USD to stabilize their assets, make trade easier, and remove speculation of possible devaluation in domestic cash.

    3. Speculation 

    Governments and investors often purchase foreign cash hoping for future appreciation. These purchases can be based on predictions of the direction of foreign cash. 

    Alternatively, a government can purchase a widely traded currency to secure future trade or invest in a stable financial system.  

    A firm understanding of currency and foreign rates is essential to knowledgeable preparation of foreign investments or a trip to the Maldives.

    Note

    You’d need to exchange your currency for Maldivian Rufiyaa (RF) for a trip to the Maldives.

    Changes in Exchange Rates

    Speaking of traveling abroad, have you ever traveled abroad? You know the messy process that trading in your money is. You go to swap your money, but you need to pay fees, and sometimes, when you trade your money, the rate changes! 

    What decides these rates? And what controls them? The deciding or controlling factors are:

    1. Supply 

    A country can control the amount of money printed and the amount in circulation. As a result, it can produce more money to spend on projects and promote the economy. Still, often, overprinting is a surefire way to cause inflation and devalue a government's money.

    2. Demand

    The demand for an exchange can come from multiple reasons. Rises in a currency’s worth could promote trade, or large government deals could call for the need for a large exchange. 

    No matter the reason, a great demand for a currency will nearly always increase the value and trade for a currency.

    These rates are similar to the price of an apple, and they follow the laws of supply and demand. But there is an added layer: Stability. 

    You’re never going to worry if the apple is never going to appear again. But what about currency? What happens when a country goes to war or a crisis occurs? What do you think would happen to a country’s money? 

    3. Stability 

    Most people forget to consider the stability of a currency. A country’s economic position can drastically affect its money’s worth.

    The stability of a currency is crucial. Inflation, interest, economic growth, and government policies all affect the stability of money. 

    No country nor everyday trader is likely to gamble on a risky bet. A government’s job is to stabilize an economy when a crisis comes. Stability is so crucial that some currencies “peg” theirs to another.

    Factors Affecting Exchange Rate

    Although supply and demand are the main drivers, many underlying factors affect them.

    Some of the factors are:

    1. Balance of Payments

    Countries with more foreign expenditures than earnings have a trade deficit. Since they lose money in foreign trade, their money devalues and loses worth. 

    2. Interest

    Interest is the cost of borrowing money. As interest rises due to government manipulation, the demand for domestic currency rises. Thus appreciating. 

    3. Inflation 

    Inflation causes the purchasing power of money to decrease. This directly affects the value of money compared to a foreign bill. 

    4. Economic Strength

    Economic strength can lead to an appreciation of a country’s money. Countries like the U.S., with large economies, have the most sought-after money globally. 

    Economic strength is good for an economy and even better for the long-term strength of a country’s foreign rates and trade.

    5. Fiscal & Monetary Policy 

    When a country’s government begins to tighten regulation around monetary policies, expenditures will decrease, and in most cases, the economy  will stabilize. These points help to increase the value of domestic cash. 

    Additionally, when a country begins to lose regulations and increase spending, it leads to inflation and a depreciation in a currency’s value. 

    Types of Exchanges Rates

    Currencies fall into two main categories: Free-Floating or Fixed. Though there are three types of exchanges rates:

    1. Free-Floating

    A Free-Floating system has no intervention. A government following this system would allow its currency’s value to move up or down purely based on foreign trade. Supply and demand dictate the movement of a free-floating currency.

    These rates marginally change hourly or daily. Banks facilitate most changes worldwide based on these trades and factors we’ve mentioned before.

    This system creates a more volatile currency. However, most governments do follow this program to a certain extent.

    But if a government intervenes in a currency, it becomes a managed currency.

    2. Managed 

    A managed system is nearly identical to a floating system. They move up and down in real-time based on foreign trade. The only difference is government intervention. Currencies managed have a limit in which they can fluctuate.

    Governments under this system will allow a range of changes, but after a certain degree of change in value has taken place, a government will intervene. They manage the rate by manipulating interest, managing foreign currency reserves, and the print of money.

    This management system provides the most possibility for future appreciation while defending it from a possible large drop in value.

    Note

    Most widely traded currencies follow a system of management and regular interventions.

    Examples of Managed Currency:

    3. Fixed

    A Fixed system has fixed exchange rates with foreign bills. Fixed rates are marginalized to stay at the same rate as another.

    Governments artificially produce this by manipulating interest and limits on imports. Fixed rates can increase the stability of a currency and promote trade.

    Examples of Fixed Currency:

    • Hong Kong Dollars (HKD) | 7.83 - 1 USD
    • United Arab Emirates Dirham (AED) | 3.67 - 1 USD
    • Barbadian Dollar (BBD) | 2.00 - 1 USD

    *Pegged rates as of 11/19/19*

    Exchange Rates Examples

    A currency, especially floating, often fluctuates in value. Mostly in small denominations, but occasionally, it can drop significantly due to outside forces. Even small changes can alter the course of trade and economic stability.

    Investors and governments need to be up-to-date and informed about current rates and even possible changes.

    A great tool to use for investors is examples of currency changes and their factors. Each change in a currency’s value directly affects a list of factors. Researching and understanding these factors help investors to notice possible indications of future fluctuations in the market.

    A lot of factors, such as employment rate, GDP, market value, economic activity, stability, and many more, determine evaluations.

    It’s important to be on the lookout for these factors. Take the time to research for yourself what happened during these years to cause these changes.

    Currencies like the rupee have weakened or depreciated in value. Beginning in 2013, the exchange from USD to INR was 1-57, but as of 2023, the rate is 1-80. 

    But other currencies like the Israeli Shekel have appreciated. In March 2020, the Shekel went from trading for ¢26 to ¢32 in November 2021. To find other exchange rates, head to the Federal Reserve Foreign Rates for current rates for USD.

    Exchange Rate FAQs

    Research and Written by William Hernandez-HanLinkedIn

    Reviewed and edited by Parul GuptaLinkedIn

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