Understanding exchange rates
Put simply, an exchange rate, is how much it costs you to exchange one currency for another. Exchange rates are one of those entities that go through continual fluctuation on a daily basis. It’s important to understand that the market prices of a currency will almost always be different to the rate you will receive from the bank when you exchange your currency. Understanding exchange rates and the factors behind their movements can be a tricky subject to get your head around. This article will hopefully help you develop an understanding of the basics.
The value of a particular currency and at any given time is determined by market forces based on trade, investment, tourism, and geo-political risk. For example, every time a tourist visits a country, the must pay for goods and services using the currency of the host country. Therefore, a tourist must exchange the currency of their home country for the local currency. This type of currency exchange is just one of the demand factors that can affect a currencies value. Another important factor of demand occurs when a foreign company seeks to do business that company in their local currency. If in investor from one country wants to invest in another, then that investment would have to be made in the local currency as well.
How to read exchange rates
Reading the changes in exchange rates is a tricky task and you will need to closely monitor a number of factors in order to fully understand what’s behind any significant change in rates.
- Differentials in Inflation: As a rule, a country which has a consistently lower rate of inflation exhibits a rising currency value, as its purchasing power increases to a greater extent relative to other currencies.
- Differentials in Interest Rates: Interest rates, inflation and exchange rates are all highly inter-connected. So for example, should a central bank decide to manipulate interest rates, this could have a dramatic effect on inflation and currency values.
- Current-Account Deficits: The current account is the balance of trade between a country and its trading partners. This reflects all the payments between countries for goods, services, interest and dividends.
- Public Debt: Countries will engage in large-scale deficit financing in order to pay for their public sector projects and governmental funding. While this activity stimulates the domestic economy, nations with large public deficits and debts are considered less attractive to many foreign investors
- Terms of Trade: This requires a ratio which compares export prices to import prices, the terms of trade is related to current accounts as well the balance of payments.
- Political Stability and Economic Performance: Foreign investors will inevitably seek out stable countries with strong economic credentials to invest their capital in.
- Central Bank actions: With interest rates in several major economies already very low (and set to stay that way for the time being), central banks and government officials are now resorting to other, less commonly used measures to directly intervene in the market and influence economic growth.
Spreads of conversion
When you go to the bank to exchange a particular currency, the bank will not give you the market price that is being given to the trader. Why? That’s because the exchange rates that the banks will set are optimum amounts that have been marked up so that the bank makes a profit off your transaction. The case is similar in terms of credit cards and other payment services where currency conversion will take place.
So, for example, if GBP to USD is costing you $1.60 at the exchange market, the bank may give you the same GBP for 1.80 USDs. The differences between the two values, i.e. 0.20 are the profit that the bank is making on every transaction.
It is extremely rare that any two currencies will be identical to one and another in terms of value, and it's also highly unlikely that any two currencies will maintain the same relative value for any sustained period of time. In Forex, the exchange rate between two currencies constantly changes, as the factors behind those changes constantly change!