Exchange rates: how do they work? This guide will help demystify them for you.
Sending money abroad typically most often involves converting your funds to another currency—a process that requires exchange rates. But what exactly is an exchange rate and how does it work?
What is an exchange rate?
An exchange rate refers to the value of a currency in relation to another.
You can also think of an exchange rate as describing how much of one currency can be bought by one unit of another. Outside of international money transfers, these rates are often spoken about in the context of overseas travel.
How are exchange rates set?
The Forex or FX for short, is the global marketplace where national currencies are exchanged for foreign trade and business.
It uses price quotes known as currency pairs to compare different currencies, which financial institutions and traders then buy and sell. As the hub of currency conversion, the foreign exchange market plays a major role in determining exchange rates.
In this example, “USD” represents the U.S. dollar as the base currency, the currency being sold. The second currency—”MXN,” or the Mexican peso in this case—is known as the quote currency.
The number that follows indicates how much of the quote currency (the peso) is needed to buy one unit of the base currency (the dollar). In the currency pair above, one U.S. dollar is equal to 22.16 Mexican pesos.
Floating Exchange Rate vs. Fixed Exchange Rate
You may have heard of exchange rates described as either “floating” or “fixed.”
These terms refer to the two ways currency prices are determined around the world.
What is a floating exchange rate?
Floating, also known as flexible exchange rates, are determined by the foreign exchange market based on currencies’ supply and demand. These exchange rates change constantly. If the demand for a specific currency rises, so does its value; conversely, if demand for a currency falls, its value will also lower in response.
What exactly causes changes in a currency’s supply and demand?
Trade is a major factor. For instance, if a country exports more than it imports, demand for its goods will be much higher—consequently, so will demand for its currency, to buy those goods. Meanwhile, there is less demand for the currency of a country that imports more than it exports.
Most countries use a floating exchange rate, including the U.S., the United Kingdom, Mexico, Germany, and Japan. However, there is further nuance within the floating exchange rate category.
What is a fixed exchange rate?
Unlike floating exchange rates, a fixed rate, or pegged rate, uses a standard set by a country’s government to determine the value of its currency. The standard could be another country’s currency or a widely used asset—for instance, oil or gold.
Compared to floating exchange rates, this type of rate keeps a currency’s value within a certain range and is generally used to maintain a stable currency.
Why have many countries moved away from fixed exchange rates?
There are challenges with maintaining a constant exchange rate, like extreme volatility and dependency on a single currency or asset. As a result, some countries have adopted aspects of floating rates, and in doing so, created hybrid exchange rate systems.
Why do exchange rates matter when sending money abroad?
Simply put, when you’re sending money abroad, you want as much money as possible to make it to the destination country.
A low exchange rate means that your money converts into fewer units of another country’s currency—and as a result, your recipient receives less money than if you had transferred your money at a high exchange rate.
Unfortunately, getting the best exchange rate for an international money transfer isn’t so straightforward.
What does this mean for your money? Even a small difference in exchange rate could mean losing hundreds of dollars to the bank or transfer company.
Whatever your needs are, Agathis is your specialist partner is cross border payments. Contact us today and together we’ll come up with the best and most cost-effective plan for your business!