How do exchange rates work? | moneyfacts.co.uk

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Published: 13/04/2021

At a glance

  • Currency exchange is the process of buying money that’s used in a different country to your own.
  • Exchange rates tell you how much your currency is worth in a foreign country, with rates usually variable and therefore constantly changing according to market conditions (though some currencies have fixed exchange rates).
  • It’s important to consider the different ways you can exchange currency to benefit from the best exchange rates.

When exchanging currency, you’re essentially buying money that’s used in a different country to your own. All countries have their own currency and each is valued differently, though some countries, such as those in the EU, share the same currency.

The exchange rate tells you how much your currency would be worth if it were to be exchanged and used in a foreign country. But it isn’t always cut and dry – exchange rates constantly fluctuate, driven by economic conditions, political activity, market movements and societal outlook, which means the value of your currency is never static. Similarly, currency exchange transactions take place 24/7, with trading activities having a key part to play in boosting or downgrading the value of different currencies.

Most exchange rates are variable, and it’s important to note that while government activity can influence those rates, most central banks don’t actively regulate them. Though there are exceptions; some exchange rates are fixed (such as in Saudi Arabia and China), in which case the government dictates when their currency’s rates will change. These fixed rates are pegged to another major global currency, such as the US dollar or yen.

How are variable exchange rates established?

Variable exchange rates are in a constant state of flux, and are typically determined by forex traders on the foreign exchange market. Supply and demand is key – if demand for a specific currency is high, the value of that currency (and therefore its exchange rate) is likely to increase. But by the same token, falling demand for a particular currency will equate to a lower value on the foreign exchange market.

Yet there are plenty of additional factors that go into the exchange rates between two currencies, such as GDP figures, inflation reports, employment statistics and interest rates, with a lot of it depending on the strength of the country’s economy and its financial stability – a strong and growing economy means investors will be more inclined to buy goods and services from that country, and so demand for its currency will rise accordingly. This also works in the opposite direction, with an unstable economy resulting in reduced investment demand and therefore a devalued currency.

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How might exchange rates affect you?

While it’s often thought that exchange rates will only impact you if you’re looking to exchange currency – be it for a holiday, sending money abroad, or perhaps to get involved in currency trading – it can actually affect you in your daily life. This is because the price of essentials, from groceries to petrol, is correlated to the value of currency. For example, if inflation in the UK increases at a rate greater than Europe, then UK goods become less competitive, exports fall and demand for Sterling also reduces. Consumers in the UK would also find European goods more desirable, increasing the availability of Sterling exchanged to Euros and again reducing its value.

But it’s especially important to consider exchange rates when you’re travelling or sending money abroad. You’ll ideally want to check how your currency compares before booking a trip – if the currency in your chosen destination is weak and yours strong, you’ll be able to buy more of it with your money and will therefore have more to spend for the same cost, though if your own currency is weak, your spending power is subsequently reduced.

Yet there are a lot of other aspects you’ll need to consider when exchanging currency yourself, which is why finding the right foreign exchange provider is essential. This is particularly the case when sending money overseas – some methods are always going to be more expensive than others, with additional transaction fees to consider, while some providers have better exchange rates than others. Using an online money transfer service can be a wise move, with specialist providers known for offering lower fees and better exchange rates than their high street counterparts. Find out more about how to find the best international money transfer service and how to send money abroad.

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Disclaimer: This information is intended solely to provide guidance and is not financial advice. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.

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At a glance

  • Currency exchange is the process of buying money that’s used in a different country to your own.
  • Exchange rates tell you how much your currency is worth in a foreign country, with rates usually variable and therefore constantly changing according to market conditions (though some currencies have fixed exchange rates).
  • It’s important to consider the different ways you can exchange currency to benefit from the best exchange rates.

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