Ultimate Guide to Understanding Exchange Rates

Calculating the Costs

If you are interested in the value of different currencies and want to get more insight into all the details of exchange rates, then this guide to understanding exchange rates is for you! At some point in our lives, there will be a need for us to exchange one currency for another. This could be for travelling purposes or to settle some expenses you may have abroad. When you find yourself in a position where you need to transfer money into a foreign currency, it would require you to have an understanding of exchange rates and the Foreign Exchange Market. 

At Sikhona Money Transfers, we understand that learning about exchange rates can be a bit confusing, especially if you are new to the concept of converting currencies. There is so much detail that needs to be understood, and because of that, we have created this comprehensive guide to discuss everything you need to know about exchange rates, the different types, and how they are calculated. Find out more below.

What is the Foreign Exchange Market?

One of the first steps to understanding how exchange rates work is by learning about the Foreign Exchange Market. This market, also known as the FX Market, is a global online network for traders to buy and sell currencies from different places around the world. Due to currencies being in demand, the Foreign Exchange Market operates twenty-four hours a day and it also determines the exchange rates for currencies that have floating rates. 

This currency marketplace is always in a state of flux because exchange rates are always changing. Those businesses which operate on an international level would know that the Foreign Exchange Market is very valuable for the functioning of international trade. 

The Foreign Exchange Market is made up of different segments, one of which is known as the Interbank Markets. The Interbank Markets is the first level in the Foreign Exchange Markets and is the place where all of the banking institutions choose to exchange different currencies. Here banks can choose to either deal directly with one another or to use an electronic brokering platform (EBP). The second level to the Foreign Exchange Market is known as the over-the-counter market. This is where regular companies and people who are interested in trading would trade. 

What is a ‘Foreign Exchange Rate’?

When we talk about a foreign exchange rate, we are referring to the rate at which one currency stands against another. This helps to show the value of different currencies. For example, in 2021, the exchange rate for 1 US dollar (USD) South African Rands (ZAR) is:

1 UDS equals 14,39 ZAR 

It should be noted that currencies will always trade in pairs. 

Foreign exchange rates have a huge impact on how different markets will choose to invest their money and create international ties with other countries. 

Understanding the Different Types of Exchange Rate

There are various types of exchange rates that you should familiarise yourself with.

The mid-market rates

The mid-market exchange rate is the middle rate between the buying and selling points of a currency pair. This is the average rate found when finalizing a transaction in the Foreign Exchange Market. Every single currency pair has a mid-market rate that is unique and agreed to by the global banking institutions. 

Free-floating

Free-floating exchange rates, also known as clean floats, are a type of currency pair that relies on the supply and demand of the currency in the market. This type of exchange rate is never the same and may vary depending on the conditions of the Foreign Exchange Market. 

When it comes to free-floating exchange rates, it is important to keep in mind that if a specific country’s supply is higher than the demand, its currency rate will start to fall. But when a country’s demand is higher than the supply that is when its currency rate will increase. 

Restricted currencies

Restricted currencies in exchange rates mean that a specific country has certain limitations and does not allow free-floating rates with their currency. As mentioned above, most currencies trade worldwide, but in the case of restricted currencies, they choose to only trade within that country’s borders and in most cases, their rates are determined by their government. 

Currency peg

A currency peg exchange rate is when one currency is connected to another. In this case, it is usually a weaker currency that ties itself to a much stronger one. Currency pegs are used to try to encourage trade between two countries by working together to reduce foreign exchange risks. Pegged exchange rates are usually set at a fixed rate and help to create a stable economy. 

Onshore and offshore

By now we know that trading in the Foreign Exchange Market is open to everyone around the world in different time zones. This is why we have onshore and offshore markets. Trading in the onshore market simply means that currencies are bought and sold locally. The onshore market is regulated and controlled by the central bank. On the other hand, trading offshore deals with foreign currencies being exchanged in overseas markets. The offshore markets are determined by the Foreign Exchange Market. 

Spot and forward

Spot foreign exchange rates refer to the price of a currency that a trader would pay for a foreign currency in another currency. Simply put, it is the current market value of a currency. The forward exchange rate is the rate for a currency that would be agreed to use in the future. The forward exchange rate is determined by how the specific currency is expected to rise and fall in the market. 

Foreign Exchange Risks

There are so many foreign exchange risks that come along with understanding exchange rates. These risks are the financial impact that occurs due to the exchange rate fluctuations. Some foreign exchange risks include, but are not limited to: 

  • Transaction risks 
  • Economic risks 
  • Translation risks 

Factors Influencing Exchange Rates

Foreign exchange rates are a key factor that can help to figure out how well a country’s economy is doing at a certain period. Each country’s foreign exchange rate provides valuable insight as to how stable a country may be. Foreign exchange rates are always changing due to the supply and demand of a country’s currency for another. Here we discuss some of the factors that may influence exchange rates.

Inflation

The inflation rate in a country can have a major negative impact on the value of that country’s currency and the rates on it for foreign exchange. Countries that have a low inflation rate would experience that their currency has a high value, whereas when countries face high inflation rates, their currency has a much lower exchange rate compared to other countries in the Foreign Exchange Market. 

If a country is also facing a lot of debt from the government, then there would be less of a chance that this country would receive foreign capital, thus leading to inflation. 

Currency demand and supply

One thing that any person interested in trading and the exchange rate is that different currencies are bought and sold with their supply and demand in the Foreign Exchange Market. if a country faces more imports than exports, there will be less demand for its currency in the Forex markets. 

Political stability

Another factor that may influence a country’s exchange rate is its political stability and economic status. Foreign investors are more attracted to countries that are facing less political struggles and have a stable economy. In most cases it is found that foreign investors tend to turn away from those countries that have a lot of political confusion. The reason behind this is that the foreign investors are looking to invest in the currencies of country’s that do not show any signs of uncertainty and will not face a reduction in the value of their currency exchange rate. 

Interest rates 

Countries around the world are constantly trying to find a balance between interest rates and inflation to have a good foreign exchange rate for their currency. Interest rates and inflation go hand in hand when it comes to foreign exchange rates because low-interest rates mean that consumers are more likely to spend. If consumer spending reaches a point where the demand is higher than the supply, then inflation occurs.  

Import and export value 

A country’s imports and export activities are other factors that can also influence the currency exchange rate. When a country has a weaker currency against another, it tends to drive more exporting and makes imports more expensive. Once the country starts facing a rise in exporting activities, it increases the currency value of that particular country.   

Tourism 

Because the exchange rate is always in a state of flux, it has a big influence on tourism and the number of tourists that will visit a country. One of the most noteworthy facts that are worth mentioning here is that in most developing countries, tourism is the biggest earner for foreign exchange. If there is a good exchange rate between the tourist’s country of origin and the destination country, it can encourage tourists to travel abroad. 

How Are Exchange Rates Calculated?

By now, I am sure that it is understood that an exchange rate is the cost price at which all traders exchange one currency for another. For a trade to successfully take place, one currency has to be exchanged for another. These two currencies that are used will be known as a currency pair. Some of the most popular currency pairs are the United States Dollar to the Euro (USD/EUR) and even the United States Dollar to the Japanese Yen (USD/JPY)

Let’s assume that you are travelling to Europe from the United States of America, you would need to change your Dollard into Euros. This is when you would be interested in calculating exchange rates of the USD/EUR to determine the value your Dollars hold against the Euro. 

If you would want to calculate how much it would cost to buy one Euro using US Dollars, you would have to divide 1 by the exchange rate. 

It is important to remember that banks add extra costs to the market price so that they can make a profit. 

A Brief History of Forex

Millions of people around the world know that forex is a market that operates twenty-four hours a day and never sleeps. If you are interested in the history of forex, read more below.

Forex trading is believed to date back to the Babylonian period. Today it is known to be one of the most liquid markets online, and the biggest too! Once coins were being produced and introduced to the markets is when gold became a very important trading tool. This led to people feeling a lot of anxiety and pressure to exchange the value of their money for gold. It was because of this that during the year 1931 the gold standard was taken away, paving the way for the Forex market to come into play. 

Modern forex trading took off in the United States of America during the 1970s once this country made its currency free-floating. 

Why We Can Trade Currencies

Thanks to the help of the internet, it has made it so easy for everyone to be able to take part in trading activities on the Foreign Exchange Market. Before this, most currency traders were big-time corporations, banks, and those people who had a high net worth.   

Nowadays even though most people have access to great internet networks, some individuals prefer to trade using banks or brokerage companies. Trading empowers everyone, not just the big companies and banks like previously. Traders have the opportunity to gain profits from their currencies fluctuating and the country’s economy grows stronger thanks to forex trading. 

We at Sikhona Money Transfers understand this and it is the main reason why we choose to offer our clients competitive exchange rates anytime they choose to use our platform to send or receive money online

Exchange Rates FAQ’s

How often do exchange rates change?

Exchange rates change every single second and are constantly changing. Most people believe that exchange rates change daily, however, this is not true. Instead, they are believed to change as the demand for that particular currency increases. The Foreign Exchange Market is always twenty-four hours a day. Tourism and international trade drive exchange rates and influence them too. 

Why do exchange rates matter when sending money abroad?

Taking exchange rates into consideration when sending money abroad is important because you would need to know how much value your money will have in the country you wish to send it to. When sending money abroad, it is useful to remember to try and get the mid-market rates to help ease your transaction. 

Why do exchange rates change?

Exchange rates are always changing due to several factors that influence them. These factors can include things such as the country’s economy, interest rate, inflation, and even the political stability of the country. Exchange rates are floating freely against one another and are also determined by the flow of it in and out of the country. 

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