What is a Conversion Rate
The conversion rate is the ratio between two currencies which shows how much of one money exchanges for another. A conversion rate is also known as foreign exchange rates. Because most currencies trade widely on global financial markets, conversion rates fluctuate regularly. This constant change can impact stock markets, interest rates, and economic activity worldwide.
BREAKING DOWN Conversion Rate
Because the conversion rate represents the price of one currency against another, it reflects the supply and demand for each currency. Supply and demand often have a basis on a country’s overall economy, interest rate, or government monetary policy. Monetary policy consists of the actions of a country's central bank, currency board or other regulatory committees who determine economic policy which affects the money supply, industry growth, interest rates, and the currency rate.
If the supply of available currency grows too large, it becomes devalued and may not be as attractive in foreign exchange markets. As a result, its price might fall. A government or central bank might take steps to increase the nation’s money supply as part of an economic stimulus policy, but that extra supply could weaken its currency worldwide.
The demand for a currency can also change. One factor that influences demand is a country’s interest rate policy. If the prevailing interest rate for currency rises, currency demand could increase as well. Individuals and organizations may prefer to hold assets in that currency instead of others. Other factors which can cause conversion rates to fluctuate include balance of trade (BOT), perceived inflation risk, and political stability.
Conversion Rate in Action
Conversion rate represents the relative value between two currencies. It is essentially the price measure of one currency against another. As the rate changes, one country's money can become weaker or stronger against other currencies. For example, if the euro/U.S. dollar conversion rate is 1.25, that means one euro can equate to $1.25 in American currency. Or if the U.S. dollar/Indian rupee conversion rate is 65.2, then one U.S. dollar is worth 65.2 Indian rupees.
If the euro/U.S. dollar conversion rate fell from 1.25 to 1.10, then one euro could only be converted into $1.10 instead of $1.25. In this case, the U.S. dollar becomes stronger against the euro and the euro weaker against the U.S. dollar. This related strength means goods and services priced in U.S. dollars become comparatively more expensive when purchased with euros. A more expensive product can be a disadvantage to U.S. businesses wishing to sell in Europe. Likewise, a stronger U.S. dollar would also make products priced in euros less expensive for buyers in the U.S. In this case, European businesses selling in the United States could benefit because prices for their products and services would seem lower.
However, if the conversion rate changes in the opposite direction, the U.S. dollar becomes weaker against the euro. If the rate rose from 1.25 to 1.35, then one euro could buy more dollar-priced goods and seem less expensive to European buyers. In turn, European businesses selling in the United States could be at a disadvantage because U.S. buyers would need more dollars to purchase items priced in euros.