In financial terms, currency exchange rate determines the value of one currency with respect to a different currency. For example, an interbank exchange rate of €0.89 to the US$1.00 means that €0.89 needs to be changed for US$1.00 or US$1.00 needs to be exchanged for €0.89. Please note that there is a difference between the rate at which the banks sell and purchase currencies in the international market and the rates at which a tourist would exchange currency in a foreign country. When you are purchasing currency from a broker, you will notice a couple of things:

  • The broker offers a different buying and selling rates for the same currency
  • The rates offered are lower than what is listed in the newspaper or all the business channels.

These are a couple of ways a currency broker makes a profit from international currency trades, other than the typical strategy of buying low and selling high in the currency market.

What determines currency exchange rate?

If you have ever even accidentally turned on any of the business news channels, you may have heard stories about the falling dollar or the rising pound sterling and so on. The following points will give you a brief idea about how the value of a currency is determined:

  • Different levels of inflation among different countries: Countries that have lower values of inflation sees their currency increase in value because its purchasing power increases compared to other currencies.
  • Different levels of interest rates among economies: The interest rate set by the governing central bank determines how much return lenders would get by pushing money into the economy. A high rate of interest will attract investors into the economy, which will result in foreign currency inflow and raise the value of the currency where the money is infused.
  • Balance of trade and current account deficits: Balance of trade is the difference between the total exports and imports in an economy. A country will have a positive balance of trade if it exports more than imports and vice versa. A current account deficit is a direct consequence of a negative balance of trade. Long story short, the economy is providing more of its currency to the international market than there is a demand for, to pay more foreign currency to foreign economies than they are earning via international trade. Hence, current account deficit lowers the value of the currency.
  • The amount of public debt: A lot of countries use debt financing to invest in public sector projects and stimulate the domestic economy. Although this sounds great on paper, a large amount of public debt will automatically result in inflation in the long term. The thing about debt is that it needs to be repaid, and a country can do that in two ways; by selling more securities or by printing more money. Both of these steps increases inflation lowers the value of the currency and makes the economy less attractive to foreigners.

Currency exchange rate is a vast and fascinating topic, discussing it in its fullest extent is beyond the scope of this short article.