What is an Exchange Rate

An exchange rate is the value of one nation's currency versus the currency of another nation or economic zone. For example, how many U.S. dollars does it take to buy one euro? As of February 23, 2019, the exchange rate is 1.13, meaning it takes $1.13 to buy €1.

Types of Exchange Rates

Free Floating

A free-floating exchange rate rises and falls due to changes in the foreign exchange market. 

Restricted Currencies

Some countries have restricted currencies, limiting their exchange to within the countries' borders. Also, a restricted currency can have its value set by the government.

Currency Peg

Sometimes a country will peg its currency to that of another nation. For instance, 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. 

Onshore Vs. Offshore

Exchange rates can also be different for the same country. In some cases, there is an onshore rate and an offshore rate. Generally, a more favorable exchange rate can often be found within a country’s border versus outside its borders. China is one major example of a country that has this rate structure. Additionally, China’s yuan is a currency that is controlled by the government. Every day, the Chinese government sets a mid-point value for the currency, allowing the yuan to trade in a band of 2% from the mid-point.

Spot vs. Forward

Exchange rates can 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. For example, let's say that traders have the view that the eurozone will ease monetary policy versus the U.S. In this case, traders could buy the dollar versus the euro, resulting in the value of the euro falling. 

Quotation

Typically, an exchange rate is 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 this case, the quotation is euro to dollar, and translates to 1 euro trading for the equivalent of $1.13 if the exchange rate is 1.13. In the case of the Japanese yen, it's USD/JPY, or dollar to yen. An exchange rate of 100 would mean that 1 dollar equals 100 yen.

Key Takeaways

  • An exchange rate is the value of a country's currency vs. that of another country or economic zone.
  • Most exchange rates are free-floating and will rise or fall based on supply and demand in the market.
  • Some currencies are not free-floating and have restrictions.

Real World Example of How Exchange Rates Work

John is traveling to Germany from his home in New York and he wants to make sure he has 200 dollars’ worth of euros when he arrives in Germany. He goes to the local currency exchange shop and sees that the current exchange rate is 1.20. It means if he exchanges $200, he will get €166.66 in return.

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

-or-

$200 ÷ 1.20 = €166.66

John has returned from the trip, and he now wants to exchange his euros for dollars. He never used his €166.66 and now sees the exchange rate has dropped to 1.15. He exchanges his €166.66, and because the rate fell when he was away, he receives only $191.67. The reason he gets less despite having the same value of euros is that the euro weakened versus the dollar during his time away.

In this case, the equation is the opposite: euros x exchange rate = dollars

-or-

€166.66 x 1.15 = $191.66

However, not all currencies work the same way. For example, 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

Let's say someone traveling to Japan wants to convert $100 into yen, and the exchange rate is 110. The traveler would get ¥11,000. To convert 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