Exchange rates form the backbone of the largest financial market in the world, the foreign exchange (forex) market.
The foreign exchange market is used for all types of currency transactions. Whether you’re going abroad on holiday, sending money to a loved one back home, or completing a business deal, if it consists of two separate currencies, the forex market is where the transaction will take place.
That’s why it’s important to know how to read, interpret, and calculate exchange rates, as they have a big impact on how much money is sent and how much money is received.
In this article, we’ll explain how to work out exchange rates, what factors affect them, how to find the best exchange rates, and much more.
How to work out exchange rates
As a rule of thumb, the first currency listed in a currency pair always relates to one unit. The second currency, in combination with the exchange rate, informs you how much of the second currency it costs to buy one unit of the first currency.
Suppose you have an exchange rate of 1.643 for the currency pair GBP/EUR. This means you would get €1.643 for every £1. If you wanted to calculate how much EUR you would receive for exchanging £2,000, you would get £2,000 x 1.643 = 3,246 EUR.
What if you wanted to interpret this exchange rate as a function of EUR, i.e., EUR equated to one unit? Simply divide 1 / 1.643 = 0.609. This means that it costs £0.609 to buy one EUR. In this case, the currency pair would be changed to 0.609 EUR/GBP – notice how the first currency is now EUR.
If you are unaware of the exchange rate, you can use a simple formula to find that out:
- Ending Amount (New Currency) / Starting Amount (Original Currency) = Exchange Rate
For instance, if you exchange 50 Canadian dollars for 75 British pounds, the exchange rate would be 1.5 CAD/GBP.
What is an exchange rate?
An exchange rate, also called the foreign exchange rate, is the value of one currency in relation to another currency. Alternatively, it can be viewed as how much money you can exchange from one currency to a foreign currency. The exchange rate can be best explained using an example.
Suppose you were travelling from your home country of England to the United States of America for a holiday. Of course, your British pounds (£) are useless in the USA since their currency is the United States dollar ($).
Therefore, before you go on holiday, you will want to ensure you convert some pounds to dollars that you can take with you. If you had a holiday budget of £1,500, how many dollars would that equate to? Well, that depends on the exchange rate you converted those pounds to dollars at
You have decided to go with your bank’s currency exchange service. They have an exchange rate of 1.133 GBP/USD. This means that for every pound you exchange, you will receive 1.133 dollars.
With your budget of £1,500 and an exchange rate of 1.133, you would receive $1,699.50.
What is the difference between floating and fixed exchange rates?
A floating exchange rate, also known as a flexible exchange rate, is one where the currency exchange rate differs depending on supply and demand levels.
For instance, if the currency’s demand is high, its value will increase compared to foreign currencies. As such, imported goods will become cheaper and going on holiday to countries abroad will become cheaper. This is because your money is now worth more than it was before. However, if a currency’s demand is low, the opposite occurs.
Since the market exchange rate is flexible, it’s constantly changing. The country’s government or central bank does not actively regulate how high or low the exchange rates reach, making it difficult to predict how valuable your money will be in the future. But, this does open the door for foreign exchange trading, where traders look to buy low, sell high, and make a profit.
On the other hand, as the name suggests, a fixed exchange rate is where a country’s currency is fixed against another currency – typically an internationally traded currency such as the US dollar.
For instance, if the government and central bank of China fix the Chinese Yuan’s exchange rate to USD, the Chinese government will buy and sell the Chinese Yuan on the forex market for dollars. They will ‘stock up’ their foreign reserves with US dollars which will help them regulate their currency against inflation and market changes.
What factors affect exchange rates?
So, we’ve established that the currency’s central bank sets fixed exchange rates. We also know that floating exchange rates are influenced by supply and demand. However, to simply leave it at that would be a huge oversimplification.
It’s much more nuanced, and a variety of factors can affect the supply and demand of currency values. Let’s take a look at the main contributors.
Forex trading
For the most part, exchange rates are determined by transactions on the forex market. The forex market is the largest and most liquid market in the world and is also where all currencies are bought and sold.
Whether transactions are made by a conglomerate involving hundreds of millions of pounds in a merger and acquisition, or by individuals on a smaller scale such as exchanging money prior to going on a holiday, all currency transactions are made on the forex market.
The forex market is open 24 hours a day since it has to cater to people from all corners of the world. This means that there are an incredibly large number of transactions every hour and day, all of which impact the exchange rate.
That’s why exchange rates between currency pairs are never constant and are always changing.
Interest rates
Interest rates and exchange rates are closely linked. When a government or financial institution changes its interest rates, there is a knock-on effect on exchange rates and vice versa.
Higher interest rates mean lenders can receive a higher return for their money compared to other countries or investment methods. This attracts foreign capital into the country, and as the demand for the currency increases, so does the exchange rate.
On the flip side, as interest rates decline, so does the exchange rate as people attempt to move their money to a currency that yields higher returns.
Inflation
Inflation is influenced by how much cash is in circulation in that particular country – supply levels. For instance, if a country has too much cash in circulation, the currency’s value will depreciate.
Not only does this mean that one unit of the currency is worth less in the country itself, but also when traded internationally on the forex market. Due to the high supply levels of the currency, it’s not worth as much since it’s readily available, thus, lowering the exchange rate.
Political and financial stability
Regardless of how well an economy is performing, political instability within a country can cause investors to worry about the long-term value of their cash. To protect the value of their money, many will pull it out and look to invest in more stable countries. These actions can reduce the exchange rate.
The same applies if a country is politically stable but not performing well economically. If investors aren’t getting good returns on their capital, they will invest their money elsewhere.
Where can you exchange money?
The most popular option for exchanging money between currencies is to go through your bank or post office. You can also go to a local foreign exchange bureau, also known as a bureau de change, or find one at the airport.
Whichever option you choose, there’s a strong chance that you won’t be offered the ‘actual’ exchange rate found on the market. This is because most service providers will charge a commission on top of each exchange rate.
This is particularly relevant for foreign exchange bureaus on your high street and at airports. Depending on how much you are exchanging, you could be losing out on up to hundreds of pounds.
How to find the best exchange rates?
The best way to get the best exchange rate possible is to do your research. You can use Google’s search function to search the current exchange rate between a currency pair or use websites such as XE and Oanda.
It will let you see if there has been a dip in the exchange rate recently or not. If there has, it may be wise to wait until the exchange rate increases again so you can get more bang for your buck.
It will also allow you to use the actual exchange rate as a benchmark and compare it to exchange rates offered by providers such as your local post office or bank. This will help you determine how much of a markup they’re charging for their services and whether it’s worth it.
How to calculate exchange rates
Suppose you are going on holiday to Thailand and need to convert British pounds into Thai Baht (THB). You started with £1,300 and ended with 54,492.96 THB. What was the exchange rate?
Simply divide the new currency by the starting currency:
54,492.96/ 1,300 = 41.92
This means the exchange rate is 41.92 GBP/THB.
How to convert money from home currency to foreign currency?
Say your home currency is British pounds (GBP), and you want to send money abroad to a friend in Mexico. Mexico’s national currency is the Mexican Pesos (MNX), which means you must convert your GBP into MNX beforehand.
Your bank has given you an exchange rate of 22.5 GBP/MNX. You want to send a total of £1,500, but how much foreign currency would that equate to? Fortunately, it’s a simple calculation.
Simply multiply the amount you want to send in pounds (1,500) by the exchange rate (22.5):
1,500 x 22.5 = 33,750.
This means that your friend will receive 33,750 MNX.
How to convert money from foreign currency to home currency?
Suppose your friend hasn’t used up all of the money you sent and has 3,300 MNX left over, which they want to give back to you.
The bank has given them an exchange rate of 24.8 GBP/MNX. How much would you receive?
Since the exchange rate has been expressed as GBP/MNX and not MNX/GBP, you can divide 3,300 by the exchange rate to determine its value in GBP:
3,300 / 24.8 = 133.07. This means you will receive 133.07 GBP.