How Do Currency Exchange Rates Work?

Finance March 09 2022

By: Tobi Abiodun

Maybe you’ve travelled to the UK or Brazil and you’ve had to change your local currency to real. Or Perhaps you’ve travelled from the USA to China and exchanged your dollars for renimbi. If so, you’ve experienced what exchange rates entail. But do you know how it works? 

If you’re not a globe-trotter, you’ve definitely heard of the latest currency updates on the news. However, do you understand its workings?

Learn about what exchange rates are, how it works, factors that can affect the value of currency in countries around the world, and why Kyshi is the best bet for you. 

What are currency exchange rates?

An exchange rate is the value of one nation's currency versus the currency of another nation or economic zone. For example, how many Pounds does it take to buy one Canadian dollar? As of February 7, 2022, the exchange rate is 1.72, meaning it takes £1.72 to buy $1.1. 

An exchange rate is quoted using an acronym for the national currency it represents. For example, the acronym GBP  represents the British  pound, while EUR represents the euro. To quote the currency pair for the pound and the euro, it would be GBP/EUR. In the case of the Japanese yen, it's GBP/JPY, or pounds to yen. An exchange rate of 100 would mean that 1 pounds equals 100 yen.

In case you’re unfamiliar with the various acronyms of currencies around the world, 

we've got some for you

Types of Exchange rates. 

There are two types of currency exchange rates. Flexible and fixed exchange rates.  We describe how they work below. 

1. Flexible rates 

Also called floating exchange rates, flexible exchange rates mean that the rate quoted at the time of a transaction may not be the final rate that applies when the transaction clears.  

Flexible exchange rates rise and fall owing to changes in the foreign exchange(fx) market. currencies/countries that have floating exchange rates are perceived as strong or weak. This depends on the market sentiment towards their country’s economy. 

2. Fixed rates. 

Also known as pegged rates, fixed rates refer to the rates the central bank of a  country sets as the official exchange rate. Usually, it is pegged against the dollar. However, other strong currencies like the euro, pound sterling, yen etc could be used. 

Imagine this scenario. For instance, if the currency to which the local currency is pegged as  the US dollar.

To keep the exchange rate fixed, the central bank holds the dollars. If the value of the local currency falls, the bank sells the dollars for local currency. That reduces the supply in the marketplace, boosting its currency's value. It also increases the supply of the dollars, sending its value down. If demand for its currency rises, it does the opposite. 

Fixed exchange rates can be advantageous in times of economic uncertainty when the markets are unstable. Developing countries and economies often peg their currencies – often to the US dollar – as the increased stability provided could encourage investment and result in lower inflation rates.

A spot exchange rate refers to the exchange rate on the spot or at that moment. 

4 Factors Affecting Currency Exchange Rates 

  Changes in Exchange rates are affected by several factors  within that country.  For countries, these factors can affect how one country trades with another. For individuals, these factors affect how much money one can get when exchanging one currency for another. 

Although it is not always easy to understand, track, or even anticipate these factors, it pays to know them, especially if you are interested in foreign currency.

However, there are five main factors that affect exchange rates. We discuss them below

1. Inflation

Inflation is the relative purchasing power of a currency compared to other currencies. For instance, it might cost one unit of a currency to buy gift hampers in one country but might cost two thousand units of another currency to buy the same gift hampers in a country with higher inflation. 

These differences in inflation is why some currencies have higher purchasing power than the others. Countries with low inflation have stronger currencies and better exchange rates than those whose inflation is through the roof. 

2. Interest rates

Interest rates are closely tied with inflation. Central banks of various countries use interest rates to control inflation within the country. 

The higher the interest rate, the more valuable the currency becomes. This attracts investors as they will exchange their currency for the higher-paying one. 

However, when the interest rates are high for too long, inflation could begin to creep in. By this, central banks must consistently adjust interest rates to maintain stability in the viability of their country’s currency.

3. Money Supply  

The Money in circulation per time affects the exchange rate of a country’s currency. 

When too much money is printed by the government, it means there’ll be too much of it chasing a few goods. The ripple effect is hyperinflation which is bad for the viability of the country’s currency. 

4. Economic growth/health

The economic growth/health of a country plays a key role in deciding its exchange rates. 

A country where most of its citizens are gainfully employed will have better exchange rates. This is because most of its citizens will have enough money to spend leading to a viable economy. This will attract foreign investment and by extension the inflation and increase the country’s exchange rate.

How to Calculate currency  exchange rates

Calculating currency exchange rates can be tricky at first. Learn how to calculate it in these simple steps. 

1. Have a grasp of the country’s exchange rate. You can get this information online, at Banks, airports or currency exchange shops. 

2. After knowing the country’s exchange rates, divide your local currency by the exchange rate. For instance, if the GBP/NGN is 563.16, and you’d like to convert  £1000 to Naira. To do this, multiply 1000 by 563.16. The result is the amount you’ll receive in Naira: N563,160. 

3.If you don’t know the exchange rate, you can use the following currency conversion calculation to find it:

Starting Amount (Original Currency) / Ending Amount (New Currency) = Exchange Rate

For example, if you exchange 1000 USD for 80 EUR, the exchange rate would be 1.25.

How to Get the Best Exchange rates?

Getting the best exchange rates could be tough if you don’t get the best remittance platform. Fortunately there’s a solution; Kyshi. Asides getting the best exchange rates, you can set your exchange rates on Kyshi. You are advised to set competitive exchange rates for your money exchange to go through seamlessly. 

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