Currency Exchange Rates Explained

Exchange rates play an increasingly prominent role in our daily lives. 20 years ago, they were a concept associated with traders and politics. Today, they underpin the prosperity of Australian small businesses, freelancers, expats, and pretty much everybody that shops online. What are FX rates has become an essential question.

The Forex market appears complex because there are many moving parts, but the mechanism is simple. The supply and demand of a currency reflects its price, but only relative to the price (therefore supply and demand) of a second currency. Hence USD-AUD, or in other words, how many Australian dollars does it take to buy a US dollar.

 

What is an Exchange Rate 

In simple terms, an exchange rate is the value of one currency compared to another. The average person may wonder what are exchange rates, or why they’re relevant to everyday life. For an Australian visiting Japan on holiday, the price of booking a hotel will depend on the exchange rate. If the Japanese Yen gets cheaper, so will the local hotels in context of Australian dollars.

This is therefore hugely important in the global economy, in which assets and services are purchased every day. Australians import many cars from Germany, for example, meaning the EUR-AUD relationship is important. Likewise, the fuel to run these cars is imported from Singapore, South Korea, and Japan. If the Australian dollar falls in value, all areas of life can be more difficult for Australian importers, which is then passed onto consumers.

The silver lining of a depreciating currency is that your exports then become more competitive – suddenly, overseas countries find your products to be cheaper, and so exports may rise. This makes currency a delicate balance, though arguably more serious issues arise from a weakened currency, in particular when repaying debt becomes more expensive.

How often do exchange rates change?

If you’re wondering what is the exchange rate at any given moment, the prices are updated in real-time on Google, Yahoo, and just about any financial news outlet. The market is open 24 hours a day (as per its global nature), but closed on weekends. 

And, “closed” simply means major financial markets like the New York Stock Exchange and LSE – which are the main drivers of large volume currency transactions – are not operating. It is of course possible, in principle, to purchase currency elsewhere on the weekend, but the provider will likely use Friday’s closing price (or act as a market maker and manage risk internally).

 

How Exchange Rates Work 

Market forces is the short way to define how exchange rates work – it’s a free market of buyers and sellers, and the more popular currencies will get more expensive, whilst the out of favour currencies get cheaper.

When talking about the forex market and changes in exchange rates, most people are referring to floating exchange rates, as these are the ones freely traded on the exchange market. Float rates are determined by supply and demand, and these are driven by a near-infinite amount of factors.

If the USD-AUD price changes from 1.53 to 1.30, it’s difficult to know whether this is because the US dollar has got weaker or if the Australian dollar has got stronger. One way to check would be to see how both the USD and AUD are fairing against other major currencies. If the AUD has stayed roughly the same against the Yen, Pound, and Euro, it’s likely that the USD has gotten weaker. However, it may be quicker to use a trade-weighted index, as explained in the next section.

Interbanking exchange rates (float rates) are constantly fluctuating when markets are open, and it is major currency pairs that have higher liquidity and volume. This means more people trade them, meaning they’re faster to trade. Using exotic or rare currencies as a comparison to the AUD could be less reliable as they may be less stable or over reactive.

 

Types of Exchange Rates 

There are a few different exchange rates to be aware of. The bilateral exchange rate is the most common, as this represents the value of one currency relative to another, as per the examples above. This doesn’t perfectly tell you the strength of a currency in general, but rather its strength in relation to one other currency.

If you’re looking to calculate the exchange rate between two currencies (perhaps there is no quote available, or you do not trust the quotes presented), you can use cross rates. This is when two different bilateral exchange rates share a common currency, meaning you can calculate the cross rate. So, if you know the AUD/USD and the GBP/USD rate, you can then calculate the AUD/GBP cross rate. Traders may also exploit this for arbitrage opportunities, or risk management hedging.

Finally, the trade-weighted index is the ultimate big-picture rate of a currency. This is when a currency is measured against a basket of currencies, so you get an idea of its overall strength, not just relative to one other currency. The weights that are used typically reflect the trade between countries, making it a relevant but not perfect outlook.

 

Factors Influencing Exchange Rates 

As we know, what determines the value of a currency is supply and demand, but what causes supply and demand? Firstly, the interest in a currency heavily depends on the interest in the economy it represents. So, if Japan announces a recession, high unemployment, and low investment, people may not move there or invest there – lowering Yen demand. 

In turn, the poor performance of the economy may mean Japan reduces interest rates, as this is a common way to spur on the economy. Interest rates and exchange rates share a close relationship – reduced interest rates are unattractive to outside savers, making the currency even less attractive. Bonds, property, and many other economic metrics can impact the confidence of currency investors.

What factors impact currency rates also depends on speculation, too. It’s not just what the economy and policies are, but what they may soon be. Most transactions in financial markets are from investors, and investors are forward-looking. This means that the price of a currency today includes the possibility of future changes in interest rates, taxes, GDP, and so on.

It’s also important to look at how does inflation impact the exchange rate, because this is a little more complex. High inflation means higher prices, and this erodes purchasing power and disposable income for residents. Ultimately, it’s something that weakens a currency because of the struggling economy. The more simple way to look at this is, inflation devalues a currency (it takes more notes to buy the same product), therefore this is reflected in its exchange rate.

 

Exchange Rate Regimes 

Each currency ascribes to an international exchange rate regime. As mentioned early, most currencies have a floating rate because they are on the open market. However, not all currencies are priced like this, it is possible to centrally control the price.

A pegged currency is one that is set to maintain the same value relative to another currency, most often the US dollar. So, as the dollar falls, the pegged currency would immediately fall in equal amounts. This helps keep currencies stable, making it popular among countries who may have otherwise high volatility, low liquidity, and unstable politics. If you’re wondering what is currency volatility or why it’s important, fast changes in currency fluctuation (unpredictable pricing) creates uncertainty which is unpopular among investors. 

There is an in-between. Managed exchanged rates, otherwise known as a dirty float, is a way in which a floated currency is heavily intervened with by the central bank to prevent undesirable valuations or volatility. In principle it’s floated, but it’s manipulated. One way may be to flood the supply of their currency in the market (i.e. by trading it with USD) to suppress its own price.

 

Conclusion 

Understanding exchange rates is crucial for both individuals and businesses in this ever-globalised economy. For those still wondering why are exchange rates necessary, almost every item in your local shop is made up of raw materials, ingredients, or labour from abroad. 

The way to determine what is a good exchange rate is to compare it in relation to other nations. Whilst it takes a great deal of economic and financial literacy to foresee future changes in exchange rates, knowing why the float rates today are what they are can help in many areas of life.