Last updated: 26th November, 2020
Understanding exchange rates – an ultimate guide
If you live abroad, own a property overseas or need to pay for expenses abroad, chances are at some point you’re going to need to transfer your money from one currency to another – that means understanding exchange rates and the foreign exchange market.
head around. That’s why we have put together an ultimate guide to understanding what exchange rates are, how they are calculated and how we can help.
What is the foreign exchange market?
The foreign exchange market (also known as Forex, FX or currency market) is a global marketplace for exchanging national currencies against one another and it is this market which determines foreign exchange rates for every currency. The main participants in the market are the large international banks.
What is a ‘foreign exchange rate’?
Currencies are always traded in pairs so the FX market determines relative value by setting the market price of one currency if paid for with by another. Put simply, a foreign exchange rate is the value of one country’s currency compared to another country’s currency. For example, if you are travelling from the UK to Spain, you will need to transfer your pounds into euros. To do this, you will need to know how many pounds there are in a euro (or vice versa). On 19 May 2020, the exchange rate between the pound (GBP) and euro (EUR) was 1.1217, which means £1 was equivalent to €1.1217 (source: Bloomberg).
What is the real-time exchange rate?
“Spot”, which can have a real-time rate, specifically refers to the settlement date of the transaction. For most currencies, it can be booked right away for settlement two business days after the execution date (or also known as D+2). Markets are open from the first hour of Monday morning in Sydney all the way through to Friday at 11:59 pm in New York, so the trading happens 24 hours/5.5 days.
During this time there is a live rate. But some data providers or FX companies may choose not to use the live rate, as they either go with a start-of-day rate (which is based on the previous day’s fix or close price), or they apply a delay.
The mid-market rate
Financial institutions sometimes talk about a mid-market rate, and this is easily defined as being the middle point between the ‘buy’ and the ‘sell’ price of two currencies. Essentially, it comes down to how much the buyer is prepared to pay and at what price the seller is prepared to sell. Market makers get the better end of the bid/ask and price takers get the worse end. Trades rarely happen at mid, though it remains a useful comparison. The spread between bid and ask is determined by the liquidity, or market depth, of the pair.
The rate you see when using public sources such as Google, Bloomberg, and Reuters to search for an exchange rate between two currencies is the real-time mid-market exchange rate. However, this rate may have a delay. Find out more about the mid-market rate in our article here.
Understanding the different types of exchange rate
Due to the fluctuating nature of money, there are several types of exchange rates that you might come across:
A free-floating exchange rate fluctuates depending on the foreign exchange market. Free-floating exchange rates are determined by the global supply and demand of the currency and this can change rapidly. Essentially, if a currency’s supply is higher than demand, the price of the currency will dip until supply equals demand, but if the demand is higher than supply, the price of the currency, relative to others, will rise.
Restricted currencies are under the control of the respective government and are usually used to guarantee a degree of monetary stability. In some cases, governments may ban citizens from holding foreign money, while other governments may block foreign money exchanges and make their currency non-convertible, preventing it from being exported.
A currency peg refers to a country ‘pegging’ its currency to another country. This means that the exchange rate between two countries will always be within a similar range. However, this requires the central bank of the currency to “defend” the peg – buying or selling their currency on the markets to make the real rate match their otherwise imaginary peg. For example, Belize have pegged their currency (Belize dollar or BZD) to the US dollar at a rate of $2. This means that USD$1 will usually be equivalent to around BZD$2. There comes a point where the central bank runs out of foreign currency, gold, or other assets to sell, and can therefore no longer defend the peg; when central bank intervention stops, currencies will quickly revert to their true market price.
Onshore and offshore
Exchange rates can also differ for what is nominally the same currency but is trading in different countries. These exchange rates are referred to as ‘onshore’ and ‘offshore’ rates and they are used if the currency is different within a country’s border. For example, China’s onshore currency circulates on China’s mainland, whereas their offshore currency circulates outside their mainland, such as in Hong Kong.
Spot and forward
Spot is an exchange rate which is based on the current market value and settles D+2 (or D+1 for US dollar/Mexican peso). The forward rate is based on current market value, too, but with a settlement date further out than spot. It is based on spot plus cost of carry. The difference between spot and forward is based on the interest rate differential between the currencies, and is equivalent to booking a spot trade now and borrowing in one currency, holding a deposit in the other, for the time difference.
Quotations are acronyms for certain currencies. For example, GBP means Great British Pound and EUR means Euro. Each trade has a base (what you’re selling) and term (what you’re buying) currency. The pair is written with the ‘bigger’ currency first, and depending on which way you want to go, you get the bid or the ask.
The overall cost
Foreign exchange services make their money through foreign exchange (FX) trading and through adding fees or commission to the services they offer to consumers. Foreign currencies are traded in pairs, such as GBP/EUR, with EUR being the base and GBP being the term. When trading, the base is worth 1 and the term is worth the amount that the base can buy. For example, £1 can buy €1.16.
Buying and selling currencies
FX companies buy and sell according to market demand, run a book and make money off the spread. Hedge funds, on the other hand, are not FX companies, but they may take ‘directional’ positions that will make or lose money depending on the rate itself.
Understanding exchange rate commission and total cost
When providing FX or international money transfer services to consumers, some services also add a mark-up, or commission, on top of the bid/ask rate that they get so that they make money on the exchange rate. If you are not doing your FX between accounts in your name held in the same place, there may also be fees to get money in (e.g. card fee) and fees to get money out (e.g. payment fee) – or these could be rolled up into one ‘fixed’ fee. For this reason, it is important to look at the total cost of your exchange or transfer of commission and fees before committing to a foreign exchange transaction or sending money abroad.
To understand the total cost of your international money transfer, look for transparency in fees and exchange rate. For example, with PagoFX you always see exactly how much you will pay and how much the recipient will receive, with clearly communicated low fees and the confidence of receiving the real-time mid-market exchange rate every time.
Foreign exchange risks
Those who exchange currencies can lose money if the market is not in their favour. For example, you may find yourself spending more money in your own currency and receiving less in the exchanged currency. That is referred to as the foreign exchange risk. However, you’re only exposed to FX risk if you have an open position, which most retail customers will not.
How are exchange rates calculated?
There is only one way to calculate exchange rates and that is through price signalling – supply and demand. Inflation and economic growth may affect the price, but you cannot calculate the rate from them.
Inflation is the increase in price and the decrease in purchasing power. High inflation means that goods have increased in price. Except when there has been a naturally associated increase in supply, it results in the demand for goods and the demand for certain currencies falling, and their overall value reducing as measured against something external.
Currency demand and supply
As currencies are treated as commodities, they are bought and sold in foreign exchange markets with their own demand and supply. The exports of a country, as well as speculators who take market risk by investing, determine a currency’s demand. On the other hand, the demand for imports by the domestic market decides a currency’s supply. This is evident when people start to buy goods from other countries and begin to transfer money internationally when prices of domestic goods rise.
Take for instance the UK’s top imports. The country purchases billions worth of US machinery like computers as well as cars and crude petroleum from Germany. In order to do this, the UK must sell pounds to buy USD and EUR. Its supply of pounds in the foreign exchange market depends on how much the country imports.
For two countries that are trading with each other, they require payments in their local currencies. Thus, they exchange currencies in the foreign exchange market. And when a currency’s demand equals its supply, the foreign exchange market generates an equilibrium exchange rate against another currency.
Exchange rates can be complicated even for the most experienced and financially savvy, though it’s not the only factor in calculating the cost of sending money abroad. Many services charge hidden fees which can be built into the exchange rate they give you or quietly added on to your transaction. With PagoFX we give you the real-time mid-market exchange rate without any kind of mark-up and we show you the fee you pay before you press send. Download PagoFX today to make international money transfers with bank-level security, transparent fees and real-time exchange rates with zero mark-up.