Understanding exchange rates may not seem exciting, but understanding and reading them could save money when making international payments. NerdWallet provides numerous helpful tools for learning how to read and calculate FX rates.
Market exchange rate
Market exchange rates reflect supply and demand factors related to each currency pair; investors’ perceptions of economic development, financial stability, and inflation rates all play an integral part. They can even influence a country’s inflation rate and balance of payments.
Small businesses should understand how market exchange rates work when making overseas transactions to keep expenses under control and secure competitive deals. Furthermore, this helps them stay abreast of trends related to exchange rates they are interested in.
In the foreign exchange market, two types of exchange rates exist: spot and forward. Spot rates reflect current market value, while forward ones account for expected changes in the near future. Several other varieties, such as middle rates and retail exchange rates, also exist.
The middle rate is the average of a currency’s buying (bid) and selling (ask) prices. It is often quoted in newspapers, magazines, and economic analyses and used as a comparison benchmark. A currency’s retail exchange rate consists of its middle rate plus any margin or markup applied by brokers to its sell-side quote from dealers.
Bank exchange rate
Exchange rates fluctuate worldwide due to numerous economic factors such as political unrest, consumer and inflation data, and changes in export values. Governments can manipulate exchange rates in many ways, including setting an official rate, floating it, or pegging it; floating rates tend to be the most popular due to market forces like supply and demand influencing them.
Bank exchange rates are the prices used by banks or money transfer services to sell and buy foreign currencies. They typically include a margin of profit that’s added onto the mid-market or interbank rate. Because margins vary depending on which provider is being considered, it is essential that you compare them before making your decision—the higher their margin is, the less money will come in when exchanging currencies.
One way to determine whether exchange rates offered by providers are fair is to compare them with the interbank rate. But be wary, as many providers add hidden costs such as service fees, landing charges, processing fees, or poor customer support services; moreover, some do not take security seriously enough. In order to avoid getting scammed, look for transparent providers like Wise that offer true interbank rates like this one.
Forward exchange rate
Forward exchange rates are an integral component of international trade, investments, and hedging strategies. They serve as an indicator for future spot exchange rates by taking into account market expectations and interest rate differentials between two countries. Their calculations involve complex financial formulae requiring careful study to fully grasp their implications in foreign currency trading.
Contrary to spot exchange rates, which are determined by market participants for immediate delivery, forward exchange rates are predetermined and applied on a future date. They’re used by businesses needing to hedge against currency fluctuations—for instance, companies in Europe importing products to America—who need protection against fluctuating exchange rates. Forward contracts may last 30-60-180 days, with options of one year being possible.
Market sentiment and economic indicators influence forward exchange rates. If investors are optimistic about an economy, its currency may appreciate, leading to lower forward rates; on the other hand, market participants who worry about its economic stability might cause its currency to depreciate further, leading to an increased forward rate.
As inflation rates can differ widely from country to country, another factor influencing forward exchange rates may be inflation differentials; investors may demand an upsurge premium when buying currency from countries whose inflation rates exceed that of the US.
Flexible exchange rate
Unlike fixed exchange rates, which are set by governments, floating or flexible exchange rates are determined by supply and demand in international money markets. Traders on these markets, which collectively are worth an estimated daily turnover of more than $6.6 trillion USD, set currency prices by purchasing and selling currencies within these markets; such traders could include individuals, banks, or firms.
Flexible exchange rates enable nations to pursue their respective monetary policies without worry over how they will impact other economies. If country A follows an inflationary monetary policy while country B pursues price stability measures, maintaining an equivalent exchange rate between their currencies can become very challenging.
A flexible exchange rate should protect a country’s economy from external shocks by allowing its currency to depreciate against external influences—hence why many developing nations still peg their currencies to foreign ones even after the collapse of the Bretton Woods system.
However, this “insulation” is in question in practice; when the dollar appreciates against emerging markets, domestic interest rates in those nations increase, decreasing risk appetite and raising required returns on EM bonds. So, even with flexible exchange rates, this system does not seem capable of protecting emerging markets from external shocks.