Exchange rates - how to understand them

Exchange Rates 101: A guide to understanding the fundamentals

If you have ever asked why some currencies are worth more than another, or why exchange rates of currencies are always a topic in the news then this article is for you. You will be learning the basics of exchange rates — what they are, why their values change every day, how they affect our daily living, and more.

Unlike before, to understand how exchange rates and currencies work, one had to read market/finance books end to end or attend personal seminars and take notes. In this day and age, with just a smart device and access to the internet, learning about exchange rates is at the tip of your fingers. There are various websites that offer free lessons on financial management, forex trading, and business management. You can choose from a whole section of summarized or full-length articles, videos, e-books, and infographic materials.

Exchange rates in a nutshell

Simply put, the exchange rate is the price of one currency in terms of another currency. That means, there are two sides: a domestic currency and a foreign currency. Exchange rates are often quoted to see how much a nation’s currency is actually worth. It helps forex traders decide how much of one currency to buy or sell, as well as when to buy or sell.

Fixed or Flexible

Exchange rates can either be fixed or flexible (also called floating). In the former, the rate is what the government’s central bank determines as its official exchange rate. In the latter, the rate is determined by the market forces of supply and demand. A floating exchange rate is often termed “self-correcting,” as any differences in supply and demand will automatically be corrected in the market. However, one must be careful to remember that these are not totally exclusive of each other. A fixed exchange rate can still be influenced by market forces, while a floating exchange rate can still be influenced by government interventions or policies.

The United States of America is one country that uses a flexible exchange rate. The value of the USD is determined by the foreign exchange market.  China, on another note, is an example of a country that adopts a fixed exchange rate. It pegs its Yuan to a targeted value against the US Dollar. How does China (or any country with a fixed exchange rate system for that matter) do it? It buys and sells large quantities of its currency and the USD to maintain that fixed value. However, the Chinese Government has allowed some flexibility into its financial system in 2015.

Direct or Indirect Quotation

Exchange rates can be quoted in two manners: directly or indirectly. In a direct quotation, the foreign currency (base currency) is “expressed” in terms of the domestic (counter currency) one. In the reverse, indirect quotation, the domestic currency (base currency) is expressed in terms of the foreign (counter currency) one. To better understand, here is an illustration: 1 USD = 51.9422 Php; 1 Php = 0.0192457. The first conversion is an example is a direct quotation, and the second, an indirect quotation of the Philippine Peso.

Usually, the US Dollar is used as the base currency to determine the strength of one’s domestic currency. Take this as an example: today, 1 USD = 51.81 PHP.  A week ago, 1 USD =  50.20 PHP. What does this mean? The Philippine peso was stronger last week than it is today. That is, economically speaking. This is good for the country’s (Philippines) economy, but bad for remittances. Remember, the closer one’s currency to the value of 1 USD, the stronger it is in the forex market.

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