How Exchange Rates Work

The exchange rate between two currencies is the value of one currency against the value of the other. It will usually be cited in one of two ways. Where two and only two currencies are commonly interchanged, as with the United States dollar and the Canadian dollar, it is most common to state the relative values as an equation: for example, 1 USD = 1.20 CAD. The currency which is set as equivalent to 1 is called the base currency, while the other is called the term currency. The financial rule is that base currencies follow the order EUR (euro), GBP (British pound), AUD (Australian dollar), NZD (New Zealand dollar), USD (United States dollar), and then everything else. However, this rule is often inverted in Great Britain and the United States, which prefer to set their own currencies as alway equal to 1. Because this inverts the roles of the term currency and the base currency, an exchange rate quoted in this way is called an indirect quotation.

Where a larger number of currencies are referenced or in the context of forex speculation, the exchange rate is more commonly expressed as a ratio: for example, EUR:USD at 1.5. Such quotations will always follow the financial rule of base currencies. An exchange rate quoted in this way is called a direct quotation.

An official exchange rate will usually be perfectly equivalent in both directions, although there can be exceptions where the exchange rate is set or closely managed by a central bank. A current official exchange rate is also known as a spot rate. This is in contrast to a forward exchange rate, which is the forex market’s equivalent of a futures quote. Forward exchange rates are also commonly used by international businesses for future pricing, invoicing, and contracts.

A spot exchange rate is usually quoted to two, three, or four decimal places, although Barclay’s Capital quotes its spot exchange rates to up to six decimal places. The lower the value of the term currency relative to the base currency, the fewer decimal places will be used, while the closer the value of the term currency relative to the base currency, the more decimal places will be used.

Economists sometimes use the distinction between nominal exchange rates and real exchange rates. The nominal exchange rate is simply the cost of a currency, expressed against the value of the local currency. Thus it will usually be an indirect quotation. In contrast, the real exchange rate is considered to be the ratio between the prices of equivalent products. In other words, it expresses the relative value of currencies in terms of what they can buy. However, since it is difficult to establish just what types of products are equivalent, as well as to allow for differing supply-demand within the two markets, the real exchange rate is really only a theoretical ideal.

Unlike official exchange rates, unofficial exchange rates will always have a gap, depending upon whether you are buying or selling the currency. This gap is how foreign exchange specialists make their profits. Outside the black market, this gap is rarely larger than 5-10% and is more commonly closer to 2%. On the black market, the gap can even completely reverse the official exchange rate. For example, before the Soviet Union collapsed, the official exchange rate of the Russian rouble was 1 rouble per 2 US dollars when buying roubles, 2 roubles per USD when selling roubles, and it was forbidden to take them out of the country. However, on the black market, the unofficial exchange rate during perestroika grew from 50 to 200 roubles per USD, with the reverse exchange almost impossible.

Currencies may be allowed to float freely on the market, in which case their value is a loose measure of the stability and strength of that country’s economy. They may also be pegged to a commodity standard, to another currency, or to a basket of currencies. Between 1944 and 1966, the 44 Allied nations committed themselves to the Bretton Woods system, pegging the value of each of their currencies to the United States dollar in order to stabilize their currencies. This allowed the USD to become the reserve currency for every signatory state until it abandoned the gold standard.

Other ways to manage exchange rates is for the central bank to become actively involved in buying and selling its own currency on the open market. As well, the international movement of a specific currency may be restricted. Where a currency is in some way restricted or managed, there may be two different versions of that currency, one which can be exchanged for foreign currency, and another which cannot, as is the case with the Cuban peso / convertible peso. In this case, there are usually strong restrictions upon citizens owning convertible currency. The Cuban convertible peso is not recognized by the International Organization for Standardization (ISO).

Three common reasons for relative currency values to change occur when a country alters its interest rate, when a major export of that country changes in value on the international markets, and when a country allows a trade deficit to grow beyond a foreseeable balance. Investors seeking high interest rates will tend to buy into the currency of those countries with higher interest rates, while those seeking cheaper loans will tend to borrow from countries with cheaper interest rates. This causes the currencies of countries with higher interest rates to rise in value. When a commodity such as oil rises in price, the currency of those countries which export oil will also rise in value, while the currencies of those countries which heavily import oil will fall. Where oil is involved, these types of currencies are sometimes called petrocurrencies. Related to this effect is the slide in its currency value when a country imports more than it exports. All these factors contribute to the net demand for a given currency.

In most managed economies, only a limited supply of currency is allowed into the market at any time, based loosely on the current GDP of that country. Releasing too much currency into the market will devalue it. At the extreme, an unregulated currency printing press will bring about hyperinflation of over 100,000%, such as is currently happening in Zimbabwe. Another catalyst for hyperinflation may be a sudden collapse of GDP or heavy costs suddenly incurred by a country’s economy, as with war reparation costs. Many European countries experienced hyperinflation between World War I and World War II.

Exchange rates for floating currencies can and do change constantly, and even stable currencies can lose 2-3% of their value relative to another currency in the space of a day. Government budgets, financial statements, the collapse of a major investment bank can all trigger a sudden slide in the value of a currency. For this reason, the exchange rates set by banks at the beginning of each business day are usually applied only to transactions below a certain amount. Above that amount, banks will use the live rate instead, which is the exchange rate at that particular minute in time.