An exchange rate tells you how much of a country’s currency you could buy with a unit of another currency.
For example, this could be converting pounds sterling (GBP) to euros (EUR).
If the market rate for GBP/EUR is 1.10, for example, you’ll get €1.10 for each £1 you exchange (assuming you get the market rate and excluding any fees).
It works the same way in reverse. The EUR/GBP rate might be 0.90, meaning you’d get £0.90 for each €1 you exchange.
So, the rate impacts the amount you get from a currency exchange.
Working out how an exchange rate will impact you
To work out how much of a currency you’ll get, just take the amount you want to exchange and multiply it by the exchange rate.
So, if you’re exchanging £500 into euros and the rate is GBP/EUR 1.10, then you’d end up with €550 (assuming you get the market rate and excluding any fees). However, if the rate was to drop slightly to GPB/EUR 1.05, then you’d end up with €525.
If you want to exchange money when you return home, you can follow the same process from euros to pounds. Say you have €200 left when you return and the rate is EUR/GBP £0.90, then you’ll get £180. Again, this assumes you get the market rate and excludes any fees.
Why are currencies exchanged?
Common reasons to exchange currencies include:
- going on holiday outside the UK
- moving outside the UK
- paying a mortgage outside the UK
- funding a child’s international education
- preparing for retirement outside the UK
But currencies are also exchanged for other reasons, such as trade (buying goods and services from another country) and investment.
What makes exchange rates move?
A currency that's rising in value may indicate that the economic health of the country (or region) is improving. Or, it may mean that there is the prospect for improvement.
Interest rates and inflation
Inflation and interest rates impact exchange rates.
Some inflation is healthy for an economy, as it shows there's an increasing demand. But too much inflation can be a problem, as goods and services become less affordable.
When setting official interest rates, central banks consider this balance. For example, the Bank of England has an inflation target of 2%, as of January 2021.
If inflation is below its target level, a central bank may look to reduce its interest rates. This can make it cheaper to borrow and less rewarding to save, which encourages people to spend. The increase in demand can push inflation higher.
But if inflation is rising too fast, a central bank may increase interest rates. Higher rates can make it more expensive to borrow and more rewarding to save, reducing demand and slowing inflation.
Higher interest rates can increase a currency’s value. They can attract more international investment, which means more money coming into a country and higher demand for the currency.
A country’s trading relationship with the rest of the world can also impact its currency. Countries that export more than they import, known as a trade surplus, will typically have stronger currencies than those with trade deficits.
Market expectations play a big part in exchange rate fluctuations. These expectations will take into account the factors above.
Other economic data, such as Gross Domestic Product (GDP) and unemployment rates, will also affect market expectations.
The economic and political stability of a country does too.