Currency Exchange Rates
In this lesson, we will explore how currency exchange rates work.
When purchasing American shares, you use dollars, while European equities are traded in
euros. But how exactly do you buy currency? You buy currency with money, of course.
You can exchange pounds for euros, dollars for yen, or yen for Australian dollars. Chances are
you’ve made an FX transaction yourself when visiting a country with a different currency than
the one used in your own country. For instance, if you live in the Eurozone and plan a trip to
the UK, you’ll need to convert some euros into pounds to make purchases in the UK.
Really what you’re doing is buying pounds and paying with euros. Basically, it’s like selling
euros for pounds and this leads us to the dual nature of money.
Money is mainly used as a means of payment, yet at the same time currencies have an
exchange value expressed in another currency. When you buy a currency, you’re selling
another simultaneously. The price of the currency you are selling is unique for each currency.
And that leads us to FX rates, or exchange rates.
FX rates or currency pairs show the relationship between one currency and another at a
specific point of time. An exchange rate represents the relative value of two currencies from
two different countries. In a currency pair, the first currency (on the left-hand side) is the base
currency, while the second currency (on the right-hand side) is the quote currency. The base
currency is always denoted in one single unit of the currency (e.g. EUR = 1) while the quote
currency fluctuates in value. Essentially, it indicates how much of the quote currency is
needed to buy a single unit of the base currency.
For instance, if the EUR/USD trades at 1.0877, it implies that 1 euro buys 1.0877 US dollars.
So, if you’re planning a trip to the US, you will need to exchange euros into US dollars. If you
exchange 1,000 euros into US dollars, with the exchange rate currently at 1.0975, you would
receive 1097.5 US dollars.
Suppose the following year the EUR/USD rate rises to 1.1000. With 1,000 euros, you can buy
1,100 USD. Although you have the same amount of euros, you receive more US dollars. This
means that the euro appreciated in comparison to the US dollar, or conversely, the US dollar
depreciated against the euro.
The exchange rate is determined by the primary market forces of supply and demand.
The goal is to buy the currency you anticipate will appreciate in value relative to the currency
you are selling. Hence, these expressions:
The euro appreciated against the dollar and
The yen depreciated against the pound
Simply stating The euro appreciated is still relevant, indicating that the euro gained value
against various other currencies, but it is still not specific. The behaviour of the euro can vary
depending on the counterpart currency. For instance, while it may appreciate against the US
dollar, it might simultaneously depreciate against the JPY for different reasons.