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.

What are currencies and how are they related to exchange rates?

In layman’s terms, currency is money that is used in a particular country, issued by the government and circulated within an economy. It is the medium of exchange for commodities.

Currencies differ from country to country. For instance, the currency in the USA is different from the currency in Japan, the Yen. Currencies do not have the same value. 1 USD is not equivalent to 1 Yen, and neither is 1 Yen equivalent to 1 Php (Philippine Peso). They have different exchange rates, depending on the performance of the currency in the world economy.

To learn more, you can watch the video prepared by Investopedia, “Currency Exchange: Floating Rate Vs. Fixed Rate,” found at: https://www.investopedia.com/articles/03/020603.asp

Why is it important to know what exchange rates are?

Exchange rates are essential to our daily operations, whether domestic or international. They affect the price of goods and services. They change and fluctuate. These changes reflect the market forces. If there is a high demand for currencies and there is a low supply, then the rates (prices) increase. Conversely, if there is a low demand, but there is a high supply of currencies, rates tend to decrease (its price will decrease).

Do exchange rates really affect us?

Of course they do! Before you even get to consume a good or service, it has already been influenced by the forex rate of the day. How so?

Think about a chocolate bar. To make one chocolate bar, different raw materials are needed. Cacao is sourced out from plantations, transported by land (or by water or air, as the case may be), which in turn relies on fuel (which may or may not be sourced out from another place, maybe even overseas). If the chocolate factory is stationed elsewhere and away from its main distribution centre, especially out of the country, labour has to be paid contingent on the exchange rates. Fuel and transportation prices are also hooked on the day’s rates. If your country’s currency shows strong performance in the market, expect cheaper prices of goods and services. If not, expect higher prices.

The most traded currencies

Most exchange ratesare decided upon by the forex, or the foreign exchange market. It is analogous to one marketplace where currencies bought and sold as commodities. There are factors that affect exchange rates, some of which are (1) the interest rate paid by the central bank of a country, (2) money supply, and (3) a country’s economic growth and financial stability.

Investopedia, a leading online financial educator, enumerated the six most traded currencies. These are:

  1. US Dollar—it is the most traded, has wide global acceptance (there are some countries that adopt the USD as the official currency in place of the domestic currency), and is used as the standard currency for many commodities
  2. Euro—the official currency of most countries in Europe, introduced in 1999
  3. Japanese Yen—the most traded currency out of Asia
  4. British Pound—a.k.a. pound sterling, which also acts as a large reserve currency
  5. Canadian Dollar—it is the foremost commodity currency, as a result of Canada being a large exporter of basic commodities as crude oil, metals, and minerals
  6. Swiss Franc—a neutral currency, considered a safe haven within the foreign exchange market.

In 2017, it was noted that the 10 most traded currencies were:

  1. Unites States Dollar – USD ($)
  2. Euro – EUR (€)
  3. Japanese Yen – JPY (¥)
  4. British Pound Sterling- GBP (£)
  5. Australian Dollar – AUD (A$)
  6. Canadian Dollar – CAD (C$)
  7. Swiss Franc – CHF (Fr)
  8. Chinese Renminbi – CNY (元)
  9. Mexican Peso – MXN ($/MEX$)
  10. Swedish Crown- SEK (kr)

5 websites that can help you learn more about exchange rates

Here are some recommended websites (common online foreign exchange brokers) that can give you a one-sitting overview and basic understanding of exchange rates:

  1. XM Global – XM Global is a licensed and regulated broker in the United Kingdom, Australia, Belize, and Cyprus. Its clientele is spread among 196 countries. It received a Silver Accreditation for Leading and Developing People. In 2017, it was also awarded Best Forex Execution Broker by Shares Magazine (UK).
  2. EToro – Etoro has been a global FinTech leader since 2007, with a clientele from over 140 countries. Through it, you can create a portfolio with cryptocurrencies, stocks, and commodities, among others.
  3. SureTrader – SureTrader is a division of Swiss America Securities, Ltd. It is an online trading platform in business since 2008. It is also licensed by the Securities Commission of the Bahamas.
  4. FxPro – FxPro is authorized and regulated by the Cyprus Securities and Exchange Commission. It has patrons from 173 countries with billions deposited to date.

Additionally, here is an open access e-book that you can consult at your own pace:

The Economist—Guide to Financial Markets: https://drive.google.com/file/d/0B_Qxj5U7eaJTZTJkODYzN2ItZjE3Yy00Y2M0LTk2ZmUtZGU0NzA3NGI4Y2Y5/view?ddrp=1&hl=en&pli=1#

Should you want to become more financially literate, you can always enrol yourself in the Investopedia Academy. There are self-paced, online courses that provide on-the-job skills, all from the world’s leader in finance and investing education. There are courses on becoming a day trader, on investing for beginners, financial modelling, and so on.

It all boils down to…

Regardless of the resources or sources you use to educate yourself about exchange rates, what matters is that you do cross-referencing and you involve yourself in the learning process by joining forums, asking questions, or enrolling in financial literacy free courses. It is up to you.

Even so, what you must always remember is that exchange rates vary from day to day. They are never permanent because they are largely dependent on supply and demand in the global market. Thus, you must verse yourself with knowledge about how they work. That way, it will be easier for you to work around forex trading and exchange rates.

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