A Primer on Exchange Rates

I’m sure all of us have at some point of time or the other used foreign currencies, and consequently, have been exposed to exchange rates. But do most of us actually understand how these rates fluctuate and work?

An exchange rate (in its purest, most unregulated form - called a floating rate) basically represents the relative demand of one country’s currency versus another (and indirectly the demand for that country’s goods and services). When one particular currency goes up or down versus another, it means that currency is more or less in demand relative to the other. Currencies are freely traded (bought and sold) like any other goods in a market, known as the Forex (FX or Foreign Exchange) market and the exchange rate is the price of buying and selling currencies.

The main driver of currency exchange rates are interest rates. When a particular country (say the UK) increases its interest rates, then investing in the UK becomes relatively more attractive than before to an American investor. He can now invest in the UK at 5% rather than yesterday’s 4%. This increase in rates means that the Pound (GBP) is now more in demand because of this extra income one can generate. Due to this, the “pound goes up”, which means that it costs more to buy Pounds (because you’re being compensated by the higher interest rates).

Similarly, when demand for American goods and services goes up relative to the UK, then more dollars are required to buy them and the demand for dollars goes up. This means that the “dollar goes up”.

Many other factors affect exchange rates. Tax Cuts, Import Tariffs, The Price of Oil (I’ll write another one on the exact effect here) etc. all affect rates because they change the relative demand for various currencies. Another major factor in the determination of rates is speculation. Speculation (buying or selling currencies expecting them to move the other way for a profit) creates virtual demand or supply. Here, investors or traders are not buying to actually use other currencies but simply making a bet on whether they’ll move up or down. But, whether the end usage is real or not, actual buying and selling of currency does take place, and therefore real prices are affected.

We’ll continue on this theme and hopefully the next time you go abroad, you’ll know why you’re paying more or less than what you paid the last time to buy a foreign currency.

Tagged as: currencies, exchange rates, foreign exchange, forex