What is an Exchange Rate?

Written by Steven Hatzakis
Fact-checked by Joey Shadeck
Edited by John Bringans

December 11, 2024

I've been trading forex for over 20 years and reviewing forex brokers for nearly a decade, so I know first-hand the importance of understanding global currency exchange rates. Exchange rates constantly fluctuate, creating both opportunities and risks for forex traders.

In this guide, I'll explore the relationship between global exchange rates and different assets, such as currencies, gold, cryptocurrencies, and stocks. I'll also take a dive into how exchange rates impact forex currency pairs, bid and ask prices, spreads, and I'll share some real-world trading scenarios.

What is an Exchange Rate?

An exchange rate determines the value of one currency relative to another. For example, the exchange rate for the euro against the U.S. dollar (remember, all forex pricing is relative) is represented as the EUR/USD currency pair. The exchange rate for the EUR/USD pair will tell you how many U.S. dollars are needed to buy one euro.

currency_exchangeExchange rates across assets

While exchange rates are most commonly associated with currencies, the concept applies to almost all financial assets. When you buy stocks, for example, you are exchanging money for shares, and there is usually a bid/ask spread in those transactions.

Bid and ask prices

For forex traders, the exchange rate is important for understanding the bid price and ask price for any given currency pair. The bid price represents what you can sell the base currency for, while the ask price is what you’ll pay to buy the base currency. The difference between these two prices is called the spread, which is – in many cases – a forex broker’s fee for facilitating your trade. Check out my guide to the best zero spread brokers to learn more about how lower spreads can impact your profitability as a forex trader.

For instance, if you wanted to sell euros and buy U.S. Dollars, you’d check the bid price of the EUR/USD pair. If the bid price is $1.1033, this means you’ll receive $1.1033 for every euro you sell. Conversely, if you want to buy euros, the ask price might be $1.1036, meaning you'd pay $1.1036 for each euro.

accessibility_newTwo sides to every trade emoji_people

Every currency trade has two sides, one buyer and one seller.

How to read exchange rates

Tip: When reading an exchange rate, remember that you’re always buying or selling the asset on the left side of the pair (the base currency) and paying with the asset on the right side (the quote currency). For example:

EUR/USD – buying or selling euros, price in USD
XAU/EUR – buying or selling Gold, price in EUR
BTC/ETH – buying or selling Bitcoin, price in ETH
AAPL/TSLA – buying or selling Apple, price in Tesla shares

currency_exchangeReminder about currency pairs

The structure of currency pairs is simple: the base asset is on the left, and the counter (or, quote) asset is on the right. If you believe an asset will increase in value, you buy the base asset. If you expect it to decrease, you sell the base asset.

Trading example

Scenario: Suppose you're analyzing a chart and anticipate a continued price drop. If the currency pair is EUR/USD and you have a bearish outlook, you would sell the base asset (euros). However, if the pair was USD/EUR, you would buy the USD, as it's the inverse pair of EUR/USD. Remember, the order of the assets in the pair is critical to making the correct trade decision.

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How foreign exchange rates work

Exchange rates in the forex (foreign exchange) market originate in the interbank market, where banks and institutional traders interact. These prices are distributed to brokers and liquidity providers, who may add a small spread or commission. This pricing update happens in real-time – typically within milliseconds. Your broker displays the exchange rate on your trading platform, whether you're using desktop software, a mobile trading app, or an API.

While exchange rates refresh constantly, your broker may only update prices after notable moves. Typically, this change is measured in fractions of a pip, depending on price fluctuations and liquidity.

currency_exchangeMore on pips

Being able to understand and calculate pips on the fly is an important skill for forex traders. Learn more by reading my educational guide, What is a pip? I also built a custom Pip Calculator for novice forex traders.

Exchange rates are live and continuously change during the trading week, which runs 24 hours a day from Sunday evening, (when Sydney opens, to Friday afternoon, when the New York market closes (learn more about forex market hours). Aside from spot forex, traders can also access other instruments like forwards, swaps, options, and futures.

How are foreign exchange rates determined?

Foreign exchange rates are driven by supply and demand in the market, with economic and geopolitical factors playing a significant role. Central banks, through their fiscal policies, interest rate decisions, and market interventions, can also influence forex prices. Large market players, such as central banks and financial institutions, often conduct trades aimed at influencing exchange rates.

Ultimately, forex prices reflect market participants’ collective perception of current and future events. With over $7.5 trillion in average daily forex market volume (according to the latest BIS Triennial Survey), the forex market is highly liquid, and price discovery is near-instantaneous.

Why exchange rates are important

Exchange rates are essential for facilitating global trade and investment. Whether you’re buying property abroad, exchanging money for a vacation, or speculating on currency price movements, exchange rates enable the seamless movement of money across borders. Efficient markets rely on exchange rates to determine asset values. When buying a stock, for instance, you are essentially exchanging your local currency for ownership in a company. This exchange typically happens in real-time through bid/ask spreads.

FAQs

What do foreign exchange rates impact?

Foreign exchange rates have a significant impact on the global economy at large. When a country's currency strengthens or weakens, it impacts import and export prices, which can lead to changes in inflation rates and central bank policies. This, in turn, affects interest rates, employment, the cost of goods and services, and national fiscal policies.

For example, a company importing goods may face higher costs if their local currency weakens against the currency of the exporting country. Conversely, a stronger local currency might present an opportunity to purchase goods at a lower price.

It’s important to remember that exchange rates are not only affected by global events, but they in turn have an impact on those sameevents. Central bank decisions, GDP data, inflation reports, and unemployment figures all play a role in shaping exchange rates.

How do exchange rates affect international trade?

When a currency appreciates, the cost of exports from that country increases, potentially reducing demand from foreign buyers. Conversely, a weaker currency makes a country's exports cheaper and more attractive to international buyers.

On the other hand, a depreciating currency can raise the cost of imports, which can lead to inflation as businesses pass on higher costs to consumers. Governments and central banks monitor these fluctuations closely to ensure they don't negatively affect their economies.

Consider a scenario where a foreign company is exporting goods to the US and expecting payment in USD. If the exchange rate changes unfavorably for the exporter between the time of the contract and the payment, they might face a loss when converting USD back to their local currency. This type of risk can often be mitigated by hedging through forex contracts.

Why do exchange rates change?

Exchange rates fluctuate due to a variety of factors, but the primary driver is supply and demand. At any given moment, the market determines the price based on how many people are buying and selling a particular currency.

Major orders can shift prices dramatically, especially in less liquid markets. For instance, a $200 million order during a quiet market period can cause a noticeable price change, whereas the same order during peak trading hours might have little effect.

Supply and demand are influenced by numerous economic and political factors, including:

Interest rate changes
Geopolitical stability
Trade balances
Government fiscal policies

All these elements contribute to the ongoing push and pull of currency values.

What is a floating exchange rate?

A floating exchange rate means the value of a currency is determined by the market and is not pegged to any specific value by a central bank. Most major currencies today, including the U.S. Dollar, euro, and Japanese Yen, operate under a floating exchange rate system.

Floating rates can also refer to dynamic spreads in forex trading. Some brokers offer variable spreads, where the difference between the bid and ask prices changes depending on market conditions. Fixed spreads, by contrast, remain constant regardless of market volatility.

Before the end of the Bretton Woods system in the 1970s, exchange rates were fixed, but today they are free-floating in most countries. Some nations, however, still employ fixed or pegged exchange rates.

How is the value of a fixed exchange rate determined?

A fixed exchange rate is determined by a government or central bank and maintained through interventions in the foreign exchange market. For example, the Hong Kong Dollar is pegged to the U.S. Dollar at a fixed rate, and the Hong Kong Monetary Authority intervenes to ensure the currency remains within a specified range.

Other times, fixed exchange rates are calculated through cross-pair formulas. For example, the GBP/JPY exchange rate can be derived by multiplying the GBP/USD rate by the USD/JPY rate.

Where can I get the best foreign exchange rate?

To get the best exchange rate when trading or converting money, it's essential to find the best forex brokers that also offer low spreads and minimal commissions. Banks and financial apps often add markups to exchange rates when converting money for travel or business purposes (though this can be avoided).

When traveling, for example, you can usually get the best exchange rate by withdrawing money directly from an ATM using a debit card, particularly one linked to a major network like Visa or MasterCard. ATMs typically offer close-to-market rates (though some fees might apply). It's best to avoid point-of-sale (PoS) conversion offers, as they often provide suboptimal rates.

For traders, using a regulated and licensed broker ensures transparency in pricing and lowers the risk of being charged excessively high spreads or commission fees. Learn more about how I track regulatory agencies by checking out our Trust Score page. Always review your broker's fee structure before entering the market.

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