What is an exchange rate?
An exchange rate, also known as the currency rate, is the price of one currency (unit of money) against another foreign currency. It tells you how much of your own currency you must pay to buy the other currency.
Bid vs. Ask Rate
The bid rate is the price at which you buy a foreign currency. The ask rate is what you receive when you sell that currency back. This difference – the spread – is important when investing in foreign stocks or ETFs, as it directly impacts your return.
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The history of the exchange rate
The exchange rate has a long history, but the major turning point came with the Gold Standard, roughly around 1870–1914. During this time, countries pegged their currency to a fixed amount of gold. This was stable, but rigid. There was little room to respond to economic changes.
After the chaos of world wars and financial crises came the Bretton Woods system. Countries pegged their currency to the US dollar, which itself had a fixed gold value. This brought a period of economic growth and stability.
Since 1971, most exchange rates have been floating. Supply and demand have determined the value of a currency ever since. This offers more flexibility but also leads to more volatility.
What is the purpose of an exchange rate?
The primary purpose of an exchange rate is to express the value of one currency in terms of another currency. It makes international trade, travel, and investing possible. It determines how much your money is worth in a different currency. Exchange rates keep the economic balance between countries in equilibrium and ensure fair competition.
Rate fluctuations can increase or decrease your return. If you understand exchange rates, you immediately understand how your international investments are performing.
How do exchange rates work?
Exchange rates move primarily due to supply and demand in the international currency market. If the demand for a currency rises, that currency becomes more expensive. If the supply of the currency increases, or if confidence falls, then the value drops. Economic performance, interest rates, inflation, and political stability influence supply and demand, causing the exchange rate to move daily. For you as an investor, these are both opportunities and risks: a smart strategy can yield profit, but rate fluctuations can also suppress your return.
What types of exchange rates are there?
There are various exchange rates that can be divided into three main types: fixed exchange rate, floating exchange rate, and a hybrid variant.
1. Fixed exchange rate
A fixed exchange rate is a system that links the value of the currency to another currency at a fixed rate, such as the Hong Kong dollar to the US dollar. This provides stability, reliability, and credibility. However, a fixed exchange rate can lead to less flexibility, as the currency cannot freely react to market fluctuations.
2. Floating exchange rate
With a floating exchange rate, the value of the currency is determined by supply and demand in the market. A good example of this is the Japanese yen against the euro. A central bank intervenes little or not at all to influence the rate. This ensures more flexibility.
3. Managed float rate
A managed float rate is a mix of a fixed and floating rate. Supply and demand primarily determine the rate, but a central bank can intervene to curb extreme fluctuations. This combination provides flexibility and stability. An example is the Danish krone against the euro.
How do you read exchange rates?
You read the exchange rate by looking at the value. If you see the following stated: ‘EUR/AUD = 1.79’? That means you can exchange 1 euro for 1.79 Australian dollars. Your euro is then worth more than an Australian dollar, but keep in mind that the values can change. If you want to exchange 100 Australian dollars into euros, you divide 100 by the current rate, in this example, 1.79.
If you, as an investor, want to invest in a foreign currency, it’s important to know that exchange rate fluctuations can affect your return. This is called exchange rate risk, also known as currency risk or FX risk. Also, factor in the exchange margin, which are costs you pay for exchanging one currency into another.
Suppose you buy stocks from the United States in euros and the dollar drops; you can suffer a loss, even if the stock price rises. The reverse is also true: if the dollar rises, you can make an extra profit. That’s why it is smart to include currency fluctuations in your investment strategy.
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All views, opinions, and analyses in this article should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.
