Daily reports about currency exchange rates hit the news. Many times this information seems unimportant, a brief blip of information that really doesn’t mean anything, unless you are traveling and need to exchange currencies. In reality, these exchange rates are very important and effect the price of merchandise at your local Wal-Mart and the price of gas.
At the most basic level, an exchange rate is simply the cost of one currency in another currency. For example, if the exchange rate between US Dollars (USD) and Canadian Dollars is 0.813 that means that it costs about $0.81 USD to purchase $1 Canadian.
Just because that is the current exchange rate does not mean that you will get that price when traveling and you need to exchange currency. When exchanging currency there is a separate exchange rate, established by the company or organization exchanging the funds, that typically includes a fee. So while the exchange rate may be $0.81 for each Canadian Dollar you may be quoted an exchange rate of $0.85.
Exchange rates change constantly. Several factors go into determining the exchange rates, including political and economic factors.
As the value, or perceived value, of a currency changes the exchange rates also change. These rates are subject to supply and demand, like most commodities. As demand for a particular currency increases the exchange rate, or price for that currency, also increases.
In the first quarter of 2008 demand for the US Dollar dropped as many currency investors sought markets that were paying more. The US Federal Reserve had dropped interest rates to be among the lowest of developed economies. As a result the value of the US Dollar dropped to roughly 1 Euro to 1.6 USD and 0.95 Japanese Yen to 1 USD.
Several factors contributed to the weakening dollar. First was that the interest rate had dropped, meaning investors could make more interest income in another currency. Second, the government was printing more money, weakening the value of each individual dollar, and third, the economic crisis confronting the United States (that caused a global economic crisis) made investing in the US unattractive.
Understanding how exchange rates are influenced and change, how do exchange rates work for consumers and businesses?
An average consumer only really worries about the actual exchange rates when trading currency. Exchange rates are always expressed as a currency pair with a corresponding number. So if the exchange rate is AUD/USD 0.66 (Australian Dollar/ US Dollar), then the exchange is $1 AUD for $0.66 USD. So if you were traveling to the US from Australia and exchanged $100 AUD you would receive $66 USD.
From a commodity standpoint, exchange rates also affect consumers by adjusting the price of goods. For example, oil is traded in USD. If the value of the dollar decreases oil prices will have to increase so that oil producers can make a comparable amount. This occurred through most of 2008 with many people accusing the oil companies of gouging up prices, but in reality it was a reaction to the declining USD exchange rate. So exchange rates work to adjust the price of goods and commodities.
For a business that operates overseas many times projects must be completed using more than one currency. One way a business can control costs and not get stuck with a devalued currency or having to convert to a currency whose value increased dramatically is to trade currencies on a forward exchange. Currency here is traded at a different rate than the current exchange rate (called the spot rate). Basically, the forward exchange is for fixing the price of a currency at some point in the future.
This involves some speculation, as no one can predict with complete certainty what a currency will be trading at in 6 months or so, but this limit’s a businesses exposure to fluctuating risk.
Exchange rates work through supply and demand and are effected by political and economic conditions. They influence exchanges between currencies and the price of goods. They can be spot rates, current rates, or forward exchange rates, with future exchange dates. With a forward exchange they can help businesses and investors hedge against exchange rate fluctuations.
Foreign currency exchange (FX trading) has become a very popular investment option in recent years and even extends into E-currencies. As with any investment decision, get all of the facts first and pay your due diligence. With a little knowledge and luck there are many great investments to be made in FX trading.