If you’re new to the financial realm, you may be wondering, “What are exchange rates? Why do they even matter?” These questions are natural for a novice to have. Below, we’ll discuss everything you need to know about these ratios.
Understanding Exchange Rates
Not every currency has the same value. To best explain this concept, we’ll offer a simple example: at the time of writing this article, the Russian Rouble equals a little more than 0.01 USD. As you can see, the Russian Rouble and US Dollar don’t offer a one-for-one trade.
Exchange rates express the price of one currency in terms of another. So, if you have 1 USD, you could also have around 73 Russian Roubles.
The Importance of an Exchange Rate
Some people may think that exchange rates are only important to investors engaged in high-stakes forex trading. However, this isn’t the case. These ratios come up when people visit or move to a different country and wish to buy products or services.
We can also think of the concept on a smaller scale. Let’s say your neighbor from Japan tried to pay you for watering their plants while they were on vacation in yen. You’d fare pretty well in Japan with 5,000 yen, but you’d be hard-pressed to spend this amount in the US.
That’s why exchange rates are so important. When you convert your main currency to the currency of the country you’re in, you can use it more easily.
When you convert money, you should understand how it will gain or lose value. A currency will appreciate if it requires more of another currency to purchase it. On the other hand, a currency will depreciate if it requires less of another currency to purchase it.
What Are the Types of Exchange Rates?
There isn’t just one type of exchange ratio. In fact, we can divide them into two distinct categories:
Fixed Exchange Rates
A fixed exchange rate doesn’t fluctuate greatly, mainly because the country’s government regulates it. Most often, the currency of these countries is tied to the US dollar (within a specific range). Some common examples of currencies that operate on this fixed basis are the Chinese Yuan and the Hong Kong Dollar.
Flexible Exchange Rates
A flexible ratio is the opposite of a fixed one — its value moves freely depending on the forex market and all the trading that occurs. Governments cannot set the value of a flexible ratio directly. However, fiscal policies can influence the value of one over the long term.
Factors That Can Affect Exchange Rates
Exchange rates may be complicated to understand at first, as several factors can influence them:
- A country’s economic situation: This factor is one of the most influential. A country with a prosperous economic environment will usually have a strong currency.
- A country’s interest rates: Countries with high interest on loans typically have more “valuable” currencies, meaning investors will buy them in hopes of generating high returns.
- The currency’s supply: If too much of a specific currency circulates, its value can drop significantly.