Exchange Rates: What They Are and How They Work

What is an exchange rate?

An exchange rate is the value at which one currency can be exchanged for another. It determines how much of currency B you receive for a unit of currency A and affects trade, tourism, foreign investment, and the price of imported goods.

Types of exchange rates

• Floating (free‑floating): Set by supply and demand in the foreign exchange (forex) market. Rates move continuously based on trading, economic data, interest rates, and market sentiment.
• Fixed (pegged): Set or tightly managed by a government or central bank against another currency. Example: the Hong Kong dollar is pegged to the U.S. dollar within a narrow band (about 7.75–7.85).
• Restricted/onshore vs offshore: Some countries limit currency convertibility or maintain different onshore and offshore rates. Example: China sets a daily midpoint for the yuan and allows trading within a small range around it.

How exchange rates are quoted

Currencies are quoted in pairs using standard codes (USD = U.S. dollar, EUR = euro, JPY = Japanese yen). The pair EUR/USD shows the value of one euro in U.S. dollars. USD/JPY shows the value of one U.S. dollar in Japanese yen.

Spot vs. forward rates

• Spot rate: The current market price for immediate exchange (cash value).
• Forward rate: The agreed price for a currency exchange at a future date, reflecting expectations about future interest rates and other factors.

Key factors that determine exchange rates

Exchange rates are influenced by many macroeconomic and market forces, including:
* Interest rate differentials between countries
* Economic growth and GDP figures
* Inflation and unemployment rates
* Trade balances (exports vs. imports)
* Central bank policies and intervention
* Market sentiment, speculation, and capital flows

The forex market

The foreign exchange market is a decentralized, over‑the‑counter market where currencies are traded 24 hours a day. Participants include central banks, commercial banks, institutional investors, corporations, and speculators. Daily turnover is measured in the trillions of dollars.

Practical examples of currency conversions

For common quote formats:

EUR/USD (dollars per euro)
* Example: Exchange rate = 1.05. Converting $200 to euros:
* $200 ÷ 1.05 = €190.48
* If later the rate falls to 1.02 and you convert €66 back to dollars:
* €66 × 1.02 = $67.32

USD/JPY (yen per dollar)
* Example: Exchange rate = 110. Converting $100 to yen:
* $100 × 110 = ¥11,000
* Converting ¥11,000 back to dollars:
* ¥11,000 ÷ 110 = $100

Note: Retail exchanges and banks add spreads or fees, so the consumer rate will differ from the market (spot) price.

Economic effects of exchange rate movements

Changes in exchange rates affect economies and businesses by:
* Altering import costs — a weaker domestic currency makes imports more expensive.
* Changing export competitiveness — a weaker domestic currency can boost exports by making them cheaper abroad.
* Influencing tourism and foreign investment — rate shifts can encourage or discourage inbound travel and capital flows.
* Affecting corporate profits and supply chain costs for firms that buy or sell internationally.

Practical tips

• For travel or small conversions, expect a margin above the market rate from banks or exchange kiosks.
• Businesses should consider hedging (using forward contracts or other instruments) to manage currency risk.
• Monitor interest rate expectations and major economic releases, as they often drive short‑term currency moves.

Bottom line

Exchange rates are central to international finance and trade. Understanding how they are quoted, what drives them, and the difference between spot and forward rates helps individuals and businesses make better decisions when dealing with cross‑border transactions.