One of the top factors to consider when transferring money overseas.
The exchange rate is the value of one country’s currency exchanged for another. Find out how exchange rates are calculated, what affects the change and where to find the best rates.
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How are rates calculated?
Exchange rates are calculated based on the currency values of the two currencies being exchanged. Take an example of the U.S. dollar and the Australian dollar. If 1 USD equals 1.03265 AUD, this means you will receive 1.03265 Australian dollars for every 1 U.S. dollar.
The same will apply if you want to know how many U.S. dollars you can purchase with 1 Australian dollar. With an exchange of 1 AUD = 0.769 USD, you will get 0.769 US dollars in exchange for 1 Australian dollar.
With these examples, if you transfer 100 Australian dollars to the U.S., the recipient will receive $76.90 USD (100 x .769). And when transferring 100 U.S. dollars to Australia, your recipient will receive $103.26 AUD (100 x 1.03265).
It is crucial to note that exchange rates can rise and fall. If a currency increases in value then it is said to have strengthened. It means that the currency will be exchanged for more against another currency. For example, if 1 AUD was being exchanged for 0.92021 USD in July and it changes to 0.9381 USD in October, then the Australian dollar is said to have strengthened against the U.S. dollar.
If a currency falls in value then it said to have weakened, meaning it will be exchanged for less against another currency. For example, if 1 AUD was being exchanged for 0.9381 USD in October and changes to 0.92021 USD in November, then the Australian dollar is said to have weakened against the U.S. dollar.
Know your values
Knowing the value of your currency in relation to foreign currencies will help you analyze investments priced in foreign currencies. For instance, for an American investor, knowing the AUD to USD relation is important if he or she was looking to buy property in Australia. The exchange rate is also useful to know for other reasons:
- If you’re planning on traveling, knowing the exchange rate shows you your purchasing power so that you can know in advance what you can purchase with a certain amount of money when you travel to a foreign country. This will help you to budget for your trip.
- Foreign exchange rates will help you decide whether to go for local products or imports from other countries. If the exchange rates from your trading partner countries are favorable then you may consider importing products if the overall cost will be lower than when you buy locally produced products. On the other hand, they will also assist you in deciding which countries to export to.
- If you regularly send money overseas — for example, to your family — you’ll want to know what the exchange rate is so you know how much money is actually reaching your destination. This is especially important if you’re making a payment overseas.
How important is the exchange rate?
A solid exchange rate is crucial. When it comes to larger amounts, even two cents in your favor can save — or cost you — hundreds of dollars. If you have the luxury of time, you may be able to take advantage of a limit order. A limit order allows you to set a target exchange rate with a service or broker, which monitors the markets 24/7 to ensure you don’t miss that target. Once rates meet what you’re looking for, you give the OK to complete the transfer. Services like OFX offer free limit orders for transfers of $35,000 and more.
When a few cents totals thousandsHow important is the exchange rate? Say you need to get 500,000 euros to a broker in Spain for a down payment on a pied-à-terre. The mid-market rate for dollars to euros is 1 USD = 0.95 EUR. You’re happy to find two online services that are pretty close to the mid-market rate — one is offering 0.93 for your dollar and the other 0.92. But to be sure which is the better deal, you crunch the numbers.
|Service A||Service B|
|Exchange rate||1 USD = 0.93 EUR||1 USD = 0.92 EUR|
|Inverse exchange rate||1 EUR = 1.075 USD||1 EUR = 1.087 USD|
|500,000 euros in dollars||$537,500||$543,500|
Finding the inverse rate, you learn that the exchange rates are a mere 1 cent difference (0.012 cents, to be exact). Yet, when applying these rates to 500,000 euros, you’d lose $6,000 to the first money transfer service on the exchange rate alone. That’s a lot of rioja you could be sipping in Madrid.
How do I find the inverse exchange rate?
The world of finance can feel hopelessly complicated. But it’s easy to find the inverse exchange rate for your currency. If you think of an exchange rate as A = B, you’d simply divide the number 1 by B: 1/B.
Take 1 USD = 0.93 EUR. To find how much 1 euro is worth in dollars using this same exchange rate, divide 1 by 0.93: 1/0.93 = 1.075. With this exchange rate, 1 euro is worth $1.075.
Why is the exchange rate I get lower than what I see on the news?
The rate you receive is lower because the rates you see on the evening news or on a business news website is the “interbank rate'” This is a rate used between banks when they buy and sell currency among themselves. The rate you receive will have a margin built into it or other fees, which makes it less competitive than the interbank rate. As a consumer, the rate you get will also depend on where you exchange your money. Providers like banks, currency exchange kiosks and PayPal traditionally offer poorer exchange rates when compared to currency exchange services like OFX and TorFx. Ensure you compare rates thoroughly before carrying out an exchange.
Where can I find the best exchange rates?
When transferring funds internationally or exchanging currency for a trip overseas, you definitely want to get the best exchange rate so as to get the most bang for your buck. The following are some of the ways you can get the best exchange rate possible.
- Avoid small currency exchange kiosks you see at airports or train stations: Although such booths may be convenient, they typically charge very high fees. They take advantage of people’s need to exchange their currencies and charge highly for their convenience.
- Use non-bank exchange services: Providers like OFX , WorldRemit and TorFX offer competitive exchange rates and low margins, therefore giving you better value. If you’re sending money overseas, these companies typically charge lower fees than traditional banks and also provide 24/7 customer support.
- Convert cash when rates are favorable: If you know that you need to make an international transfer or you will be traveling overseas in the near future, monitor the exchange rates and exchange your cash when rates are favorable to you. Carry out your conversion at an exchange provider that charges low fees and has a competitive rate, and you’ll benefit by saving money.
- Use a travel money card: These allow you to load money onto your card and lock in an exchange rate at the time of loading. This means you’re protected if rates drop and won’t pay any foreign transaction fees when spending in a currency you’ve loaded onto the card. Compare cards to see what exchange rates you’ll be able to receive before deciding on any one card.
How do exchange rates work?
Exchange rates can be either flexible or fixed. Flexible exchange rates are determined by the foreign exchange market, commonly known as the forex market. Flexible exchange rates change throughout the day depending on what traders think the currency is worth and other factors. Flexible exchange rates are said to be “floating” and can fluctuate regularly due to factors listed below.
The opposite of a flexible rate is a fixed, or pegged, rate. This is where a currency’s value is maintained against another by its government. In this case, a government will set a price against a major currency like the euro, Japanese yen or U.S. dollar and then to maintain this rate they’ll need to reserve an amount of this foreign currency. Then, if demand for this currency drives the exchange rate up they’ll need to release more of this foreign currency into the market to meet the demand, and if demand is low they’ll have to do the opposite and buy this currency.
As many will quickly point out, the majority of exchange rates aren’t purely floating or purely pegged. Most pegged rate systems will rely on a floated currency as mentioned above, so they are really using a “floating peg” system. And most floating currencies are influenced by their government’s economic policies such as tax cuts.
Exchange rates are some of the major determinants of a country’s economic performance. This is because no country is an island and each depends on foreign trade with other countries across the world to sustain its economy. For example, Australia’s economy cannot be stable without trading with the U.S., Africa, China and the U.K., among other countries. So exchange rates will affect both imports and exports, and in turn influence the balance of trade of a country. Besides demand and supply being the main determinant of foreign exchange, there are a number of underlying factors, both geopolitical and economic, that affect the exchange rate, but some of the most common include:
- Interest rates
Interest rates charged by the central bank in a particular country will affect the currency value of that country. A country whose central bank has higher interest rates will give lenders higher returns, and this tends to attract foreign investors. As a result, the exchange rate will increase. Consequently, higher interest rates will increase the exchange rate of a country, mainly when other factors of the economy remain stable and the interest rate is the major factor to influence the economy.
For example, if the American central banking system is offering high interest rates, then investors from foreign countries such as the U.K. and Australia are likely to be attracted to invest in the U.S. As a result of this, the exchange rates for the U.S. dollar will rise due to the increased demand.
- Terms of trade
The terms of trade of a country are determined by the balance between exports and imports. If the prices of exports from a country rise more than those of its imports, the terms of trade in that particular country will be greatly improved. This basically means that the country’s exports are in high demand. The final results will be that the country will receive more revenue from its exports and its currency will also be in high demand, leading to an increase in the currency’s value.
The reverse will happen if the country’s export prices rise by a smaller rate than that of its imports. The demand for exports will be low and the country will be importing more than its exports. This will decrease its currency’s demand and value.
So if the U.S. is exporting more goods to foreign countries, then its currency is likely to be in high demand and exchange rates will be higher.
A country with lower inflation rates will have a high currency value because its purchasing power increases in comparison with other countries. Consequently, when a country is affected by the ongoing worldwide economic crises, its inflation will definitely increase. This will reduce the country’s purchasing power, depreciate its currency exchange rates and its trading partners will perform better than it.
Countries with relatively low inflation rates such as the U.S., Canada, Germany, Japan, Switzerland and Australia normally have high purchasing power and their currency values do not depreciate much.
- Political climate
No investor will take the risk of investing in a country that is politically unstable. Investors will look for countries with a stable political climate so that their capital is safely invested. Generally, countries with a stable political climate will have strong economic performance and will attract more investors.
Consequently, an unstable political climate will cause a loss of confidence in a country’s currency and this will lower its exchange rate.
- Public debt
A country with high public debt is likely to welcome inflation, and this may mean that the country will have to do everything possible to pay off the debt, even if it means printing money for that purpose. When this happens, the currency value of that particular country will be reduced and this will lower its exchange rate.
Consequently, a country with high public debt will lower its currency exchange rate and this will not attract foreigner investors because their investment will be at risk.
Who do exchange rates affect?
In general, fluctuating rates affect a range of stakeholders, including:
- Travelers – When you travel overseas you may have less or more money to spend depending on the strengths or weaknesses of the currencies you’re trading.
- Locals – If your country has a strong foreign currency you may see some imported items become cheaper while other items become more expensive.
- Importers – If you import goods into your country you may pay more or less (depending on how the rates have fluctuated) for the same goods.
- Exporters – If you sell goods to other countries you may pay more or less for the same goods.
- Investors – Many trade in foreign currencies, so a drop in the value of a currency they’re trading will mean losses, while a gain will see profits.