What Is a Conversion Rate?
A conversion rate is the ratio between two currencies, most commonly used in foreign exchange markets, which designates how much of one currency is needed to exchange for the equivalent value of another currency. Conversion rates fluctuate regularly for all currencies traded in forex markets. Forex spot prices are quoted continuously with one day's break over weekends.
- Conversion rates designate how much of one currency is needed to purchase goods using another currency.
- Conversion rates are equivalent to exchange rates and spot prices in the forex market.
- Conversion rates are affected by relative supply and demand.
- Central banks and governments adopt policies to respond to the effects of supply and demand which would impact the conversion rate.
Understanding Conversion Rates
A conversion rate designates how much an individual or corporation needs of one currency to transact a desired amount in another currency. A simple example might be that if a buyer has U.S. dollars and wants to buy a vehicle owned by a seller in Germany, they may need to pay for the vehicle in euros. If the price is given as 20,000 euros and the conversion rate is 1.2, then the buyer knows they need at least 24,000 U.S. dollars (20,000 x 1.2 dollars) to acquire 20,000 euros and purchase the vehicle.
Because a conversion rate represents the price of one currency denominated by another, it also reflects the relative 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.
If the supply of available currency grows larger than the number of consumers or investors who demand its use, then that currency's value falls as it becomes less attractive in foreign exchange markets. As a result, that currency's conversion rate may increase relative to other currencies.
A government or central bank might take steps to increase or decrease the nation’s money supply as part of an effort to regulate the conversion ratio of their currency. This may be done at the behest of the country's government for reasons of economic stimulus or austerity policies, but supply changes are part of the equation that central banks can have control over.
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
The 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 (INR) 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 relative 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 then 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.