Exchange rates: how do they work? This guide will help demystify them for you. Here at Remitly, we look at them every day and we’re always working to find our customers the best deal.
Let’s say you’re planning on sending money to the Philippines from the U.S., whether as a remittance, gift, or investment in a friend’s business. Even though you’re sending U.S. dollars, chances are your recipient would like to receive the funds as Philippine pesos, the official currency of the Philippines.
Whether you use a bank or money transfer service, your money will likely be converted to Philippine pesos along the way using an exchange rate.
It’s not just the Philippines, though. No matter your destination country, 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—for example, how many Mexican pesos are equal to one U.S. dollar.
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 foreign exchange market, also called 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.
Here’s an example of how currency pairs are used to represent 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 exchange rates, 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.
For instance, some countries use a managed floating exchange rate (or a “dirty float”), in which exchange rates fluctuate based on the forex market but can be influenced by a country’s government or central bank.
A managed float is separate from a pure exchange rate (or “clean float”), in which the value of a currency is solely based on the market’s supply and demand; in other words, the government cannot intervene to change its value.
What is a fixed exchange rate?
Unlike floating exchange rates, a fixed exchange 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.
Historically, much of the world, including the U.S., used the gold standard in a fixed exchange rate system. In this system, countries set a fixed price for gold and based the value of their currency on that price.
Today, fixed exchange rate systems aren’t so common, but countries that do use a fixed rate typically peg the rate against the U.S. dollar. These include Belize, Cuba, Qatar, Hong Kong, and the United Arab Emirates.
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.
For example, Singapore pegs its currency to what’s known as a “currency basket,” the weighted average of several of its major trading partners’ currencies.
What is the “mid-market” rate?
Also known as the interbank or middle rate, the mid-market rate is the midpoint between a currency’s bid and ask rates.
Or, in simpler terms, the mid-market rate is the average between how much buyers are willing to pay for a specific currency, and how much sellers are willing to sell it.
Since this rate is influenced by ongoing transactions in the foreign exchange market, you can think of the mid-market rate as the “real” exchange rate—the one that captures the true value of how much a currency is worth.
Which is better: a “high” or “low” exchange rate?
Maybe you’ve heard the words “high” and “low” used to describe exchange rates, probably in the context of one being better than the other.
In reality, neither is inherently better than the other. When you prefer a high exchange rate versus a low one, or vice versa, depends on how you plan to use a specific currency.
When it comes to sending money internationally, a high exchange rate is preferable. Why? Because it means your money is equal to more units of another currency. In fact, a currency that benefits from a high exchange rate is often labeled as “strong.”
To illustrate the difference between high and low rates, take a look at these two hypothetical exchange rates for the U.S. dollar to the Indian rupee.
- USD/INR 76.970
- USD/INR 71.671
In the first example, one U.S. dollar is equal to 76.970 Indian rupees. That’s a high exchange rate compared to the second rate, in which one U.S. dollar is equal to 71.671 Indian rupees.
The second exchange rate is considered low because the U.S. dollar cannot buy as many Indian rupees—about five less than the first rate.
A low exchange rate isn’t desirable when sending money abroad because your recipient is getting less than they otherwise might have received with a higher rate.
For this reason, a low exchange rate is preferable when you’re selling currency.
How often do exchange rates change?
With bankers and traders buying and selling currencies 24/7 in the foreign exchange market, exchange rates are always changing—not just once per day, but multiple times.
Because of this, the value of a currency never stands still.
How is an exchange rate determined?
Put simply, the value of a currency and its exchange rates are determined based on how desirable it is to hold that specific currency.
There is no single telltale sign that influences this perception of desirability but rather, several factors that reflect a country’s economic health. These include a country’s:
- Interest rate
- Balance of trade
- Political and economic stability
- Government debt
An interest rate is the amount a lender charges for borrowing money, usually written as a percentage. In the U.S., the Federal Reserve Board meets regularly about the federal funds rate, the interest rate used by banks for lending.
Interest rate is strongly connected to foreign exchange rates and inflation, so much so that central banks influence exchange rates by manipulating their interest rates.
A higher interest rate generally increases a currency’s exchange rate because it attracts foreign investors, meaning greater returns for anyone lending money.
The opposite happens for low interest rates: when an interest rate decreases, so does the exchange rate. However, inflation plays a role in that if a country has a high inflation rate, a high interest rate has little effect on a currency’s value.
In other words, interest rate alone isn’t enough to increase a currency’s value and exchange rate.
Balance of Trade (or Supply and Demand)
Balance of trade refers to the relationship between a country’s exports and its imports. If uneven, the exchange rate is affected because of trade’s impact on the supply and demand for a currency.
For example, if a country exports more than it imports, this usually indicates a greater demand for its goods. Households that buy imported goods will need foreign currency to pay for them; so do any investors looking to invest in that foreign country.
Because of this, the demand for its currency will be higher, but if not much is in circulation, its value and exchange rate increase.
On the other hand, a country that imports more than it exports faces the opposite situation. Because its exports aren’t so high, there is less demand for the currency of that country—meaning its exchange rate will also be lower.
Alternatively, if a government prints too much currency, it will have an excess supply of money. This can cause inflation and effectively lower the value of a nation’s currency and exchange rates.
Political and Economic Stability
Both politics and the economy can affect a country’s exchange rates. Major events may cause uncertainty for foreign investors, and in turn, negatively influence their behavior.
That’s because investors want to feel confident about a country, and political or economic unrest signify risk.
But if a country shows signs of economic growth and stability, it will remain an attractive investment opportunity. More investors will seek out its goods and services, driving up the demand for its currency and as a result, increasing its exchange rates.
The size of a country’s debt can also influence its currency’s value and exchange rate. A large debt may discourage foreign investors who, concerned that a government may default on its debt, would prefer to invest elsewhere.
Additionally, because a large debt affects a currency’s value, it can also indirectly lead to inflation. As a result, the exchange rate will lower.
Less debt, on the other hand, can make a country more attractive to investors, especially when combined with promising economic growth.
This will lead to an increased demand for its currency, and thus, a higher exchange rate.
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.
That’s because it’s hard to find a bank or transfer service that uses the mid-market rate. Instead, most providers adjust their exchange rate to be in their own favor as a fee for their transfer services.
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.
Sending money abroad affordably and conveniently
With a strong understanding of exchange rates, you’ll be better prepared to send money abroad. But where do you get started?
Consider using Remitly. Our app makes sending money around the world both fast and convenient—but most importantly, Remitly uses fair exchange rates so that neither you nor your recipient lose out to expensive currency conversions.