Exchange Rates: What They Are, How They Work, and Why They Fluctuate

What Is an Exchange Rate?

An exchange rate is the value of a nation's currency when it is traded for another currency. The relative strength or weakness of a nation's currency has a strong impact on its trade with other nations, on its tourism industry, and on the prices its consumers pay for imports.

Exchange rates are always viewed in relation to the exchange rate of another currency. For example, the exchange rate from U.S. dollars to euros was 1.07 at the end of June 2024. That means one euro could be exchanged for $1.07.

Understanding Exchange Rates

The exchange rate between any two currencies is commonly determined by interest rates, economic activity, gross domestic product, and the unemployment rate in each of the countries.

Commonly called market exchange rates, currency prices are set in the global marketplace where financial institutions, money managers, and speculators trade currencies around the clock. This is called the forex or f/x market, although the market has no physical presence and no owner. Changes in rates can occur hourly or daily with small changes or in large incremental shifts.

An exchange rate is commonly quoted using an acronym for the national currency it represents. "USD" represents the U.S. dollar. "EUR" represents the euro. It would be EUR/USD if you were quoting the currency pair for the dollar and the euro.

How Exchange Rates Fluctuate

Exchange rates can be free-floating or fixed. A free-floating exchange rate rises and falls due to changes in the foreign exchange market. A fixed exchange rate is pegged to the value of another currency. The Hong Kong dollar is pegged to the U.S. dollar in a range of 7.75 to 7.85, so the value of the Hong Kong dollar to the U.S. dollar will remain within this range.

Exchange rates have a spot rate or cash value that's the current market value. They may also have a forward value that's based on expectations for the currency to rise or fall versus its spot price. 

Forward rate values fluctuate due to changes in expectations for future interest rates in one country versus another. Traders may buy the dollar versus the euro if they speculate that the eurozone will ease monetary policy versus the U.S., causing a downward trend in the value of the euro.

Exchange Rate Examples

A traveler to Germany from the U.S. wants $200 for the equivalent amount of euros on arrival in Germany. The sell rate is the rate at which a traveler sells foreign currency in exchange for local currency. The buy rate is the rate at which one buys foreign currency back from travelers to exchange it for local currency.

If the current exchange rate is 1.05, $200 will net €190.48 in return. In this case, the equation is: dollars ÷ exchange rate = euro:

$200 ÷ 1.05 = €190.48

Suppose €66 is remaining after the trip. The change from euros to dollars will be $67.32 if the exchange rate has dropped to 1.02:

€66 x 1.02 = $67.32

The Japanese yen is calculated differently. The dollar is placed in front of the yen in this case, as in USD/JPY. The equation for USD/JPY is dollars x exchange rate = yen.

A traveler to Japan would get ¥11,000 if they want to convert $100 into yen and the exchange rate is 110. Convert the yen back into dollars by dividing the amount of the currency by the exchange rate:

$100 x 110 = ¥11,000.00

-or-

¥11,000.00/110= $100

Note that none of these travelers will be getting the market price when they exchange currency. The bank or currency exchange store that they do business with will add its fee to the transaction.

The Bottom Line

An exchange rate is the value of one currency in relation to the value of another currency. Most exchange rates are floating and rise or fall based on the supply and demand in the foreign exchange market but some are pegged to another country's currency or are fixed in value.

Fluctuations in a nation's exchange rate have an impact on the demand for its products abroad and the prices its consumers pay for imports.