Exchange Rates: What They Are, How They Work, Why They Fluctuate

What Is an Exchange Rate?

An exchange rate is a rate at which one currency will be exchanged for another currency and affects trade and the movement of money between countries.

Exchange rates are impacted by both the domestic currency value and the foreign currency value. In July 2022, the exchange rate from U.S. Dollars to the Euro was 1.02, meaning it takes $1.02 to buy €1.

Understanding Exchange Rates

The exchange rate between two currencies is commonly determined by the economic activity, market interest rates, gross domestic product, and unemployment rate in each of the countries. Commonly called market exchange rates, they are set in the global financial marketplace, where banks and other financial institutions trade currencies around the clock based on these factors. Changes in rates can occur hourly or daily with small changes or in large incremental shifts.

An exchange rate is commonly quoted using an acronym for the national currency it represents. For example, the acronym USD represents the U.S. dollar, while EUR represents the euro. To quote the currency pair for the dollar and the euro, it would be EUR/USD. In the case of the Japanese yen, it's USD/JPY, or dollar to yen. An exchange rate of 100 means that 1 dollar equals 100 yen.

How Exchange Rates Fluctuate

Exchange rates can be free-floating or fixed. A free-floating exchange rate rises and falls due to changes in the foreign exchange market. A fixed exchange rate is pegged to the value of another currency. The Hong Kong dollar is pegged to the U.S. dollar in a range of 7.75 to 7.85. This means the value of the Hong Kong dollar to the U.S. dollar will remain within this range.

Exchange rates have what is called a spot rate, or cash value, which is the current market value. Alternatively, an exchange rate may have a forward value, which is based on expectations for the currency to rise or fall versus its spot price. 

Forward rate values may fluctuate due to changes in expectations for future interest rates in one country versus another. If traders speculate that the eurozone will ease monetary policy versus the U.S., they may buy the dollar versus the euro, resulting in a downward trend in the value of the euro. 

Exchange Rate Example

A traveler to Germany from the U.S. wants 200 USD worth of EUR when arriving in Germany. The sell rate is the rate at which a traveler sells foreign currency in exchange for local currency. The buy rate is the rate at which one buys foreign currency back from travelers to exchange it for local currency.

If the current exchange rate is 1.05, $200 will net €190.48 in return.

In this case, the equation is: dollars ÷ exchange rate = euro

$200 ÷ 1.05 = €190.48

After the trip, suppose €66 is remaining. If the exchange rate has dropped to 1.02, the change from euros to dollars will be $67.32.

€66 x 1.02 = $67.32

The Japanese yen is calculated differently. In this case, the dollar is placed in front of the yen, as in USD/JPY.

The equation for USD/JPY is: dollars x exchange rate = yen

If a traveler to Japan wants to convert $100 into yen and the exchange rate is 110, the traveler would get ¥11,000. To convert the yen back into dollars one needs to divide the amount of the currency by the exchange rate.

$100 x 110 = ¥11,000.00

-or-

¥11,000.00/110= $100

The Bottom Line

An exchange rate is a rate at which one currency will be exchanged for another currency. While most exchange rates are floating and will rise or fall based on the supply and demand in the market, some exchange rates are pegged or fixed to the value of a specific country's currency. Exchange rate changes affect businesses and the cost of supplies and demand for their products in the international marketplace.