What is exchange rate?

Exchange rates represent the value of one currency in relation to another. Their significance within the world of finance lies in their influence in international trade and investments, as well as their role as a marker for economic stability. Fluctuations in exchange rates can impact the cost of imports and exports, affect inflation, and determine the profitability of foreign investments, ultimately shaping economic policies and business strategies.

The exchange rate among different currencies depends on economic activity, GDP, and unemployment rates of each country. Currency prices are set within an international marketplace that consists of financial institutions, money managers, or speculators who trade in currencies. Changing rates can happen daily or hourly, with small changes, or with massive shifts. Currency rates can often be described using the acronym of a country's currency, such as USD for the US dollar.

What moves exchange rate numbers?

Several factors influence how exchange rates go up and down with one currency relative to the others, with many of them going a long way toward helping signify how each country is performing economically in that moment in time. Here are a few of the more common and prominent ones that you can find impacting exchange rate movement:

Interest rates

Higher rates offer lenders a higher return relative to other countries, attracting foreign capital and causing a country's currency to appreciate. Investors commonly track each nation's interest rates as a means to help gauge its economy's strength in the current moment.

Inflation rates

Countries with lower inflation typically see an appreciation in their currency, as purchasing power increases relative to other currencies. Naturally, a higher inflation rate leads to less purchasing power parity less willingness to spend among the general public.

Economic indicators

Data such as GDP growth, employment rates, and manufacturing output can signal economic strength and bolster investor confidence. These are common figures to observe for any serious investor.

Political stability

In some countries political situations influence currency values or exchange rates. Political tensions and instability increases risk tend to attract fewer foreign investors as they feel less confident in their ability to protect their investments. Countries with stable governments attract more foreign investment, boosting the supply and demand for their currency.

Global happenings

Natural disasters, geopolitical events, and shifts in the global economy and market forces can create volatility in exchange rates.

Although at times the movement in exchange rate figures might seem complex or illogical, and sometimes that might even be the case, understanding these factors and their impact on each nation can help further your comprehension for informed investment decisions.

Measuring exchange rates

Fundamental to investors is understanding how it works when measuring the exchange rate volatility and rates. There are several ways to do so, each with a specific market or situation for which it is most commonly used. The exchange rate is constantly changing and therefore has various measurement and interpretation options.

Spot exchange rate

Spot exchange rates display the current price at which one currency can be exchanged for another. This method of measurement is commonly used for immediate transactions in the foreign exchange market.

Nominal exchange rate

Nominal exchange rates measure the rate at which a currency can be exchanged for another without adjusting for inflation. This method provides a straightforward comparison of currency values, leaving additional nuances out of the equation to give a simpler look at monetary policy.

Bilateral exchange rate

Bilateral exchange rates refer to the relative values of two currencies. These types of currency exchange rates, are widely reported and extremely accessible in daily life as essential tools for international travel as well as global investing.

The bilateral official exchange rate is usually used against the US dollar, which is the largest traded currency. Let's take the AUD/USD conversion rate, which gives you the dollar value that you will pay for every Australian dollar you convert. An example of this is a dollar-to-dollar conversion rate of 0.75 means you will receive US 76.95 per USD 1 convertible into dollars.

Cross exchange rate

An additional use of bilateral exchange rates is its role in calculating cross rates. Inter-country exchange rates represent exchange rates determined in reference to a third country. For instance, a fixed exchange rate for the euro against the US dollar a conversion rate for both the Australian dollar and the euro against the Australian dollar is available for calculation using USD/US dollar exchange rate. The cross rate helps to determine the value of once currency to another when there is no direct exchange rate available.

Trade-weighted index (TWI)

If the bilateral currency exchange rate is the most frequently mentioned national currency exchange rate in the US, the trade-weighted index, or TWI, is the most common measure of foreign currency prices versus another currency as weighted averages for groups and baskets. The measure is a bit more involved than the bilateral method of only comparing one currency to another while ignoring the rest of the world's currencies.

With TWI, each currency is generally weighted based upon the share of trade carried out with each of their corresponding countries. This helps assess the overall strength or weakness of a one country's currency, in relation to its trade relationships. Essentially, the TWI measures the value of an asset and how it reflects it.

Direct quotation vs. indirect quotation

Direct quotation and indirect quotation are two ways to express exchange rates, each with distinct characteristics.

Direct quotation expresses the value of a foreign currency in terms of the domestic currency. If you live in the U.S., an example of a direct quotation would read like 1 GBP = 1.20 USD. This is most commonly used in countries where the domestic capital is stronger or more stable, and shows how much of the domestic money is needed to purchase one unit of the foreign one being compared.

Conversely, an indirect quotation expresses the value of the domestic currency in terms of the foreign currency. In the U.K., an indirect quotation for the Euro might be 1 EUR = 0.81 GBP. This is used more often when the foreign is more dominant than the domestic.

Direct quotes are typically easier for consumers to understand and therefore are deployed more commonly in public-facing literature and news about financial markets. Indirect quotations might require conversions for practical use, but can highlight currency volatility or economic challenges when presented in its original form.