Why do exchange rates fluctuate?
What is a foreign exchange rate?
A foreign exchange rate is the price you can exchange one currency for another.
How are exchange rates calculated?
Exchange rates take place in pairs, showing the value of one currency in terms of the other.
Suppose you were travelling to Spain and wanted to purchase travel money. In that case, you would visit a bureau de change or exchange online to exchange GBP (British pound sterling) for EUR (euro). If the exchange rate is 1.15, you could exchange £1 for €1.15.
Factors influencing exchange rates
Interest rates
When a country has high interest rates, it’s attractive for foreign investors to put their money into businesses there since they can potentially make more money on their investments. This type of investment is called foreign direct investment, where people from one country invest in businesses in another.
To make the investment, they need to convert their money into the country’s currency, which is known as a capital flow. Foreign direct investment increases a country’s capital flow, leading to higher demand for its currency and causing the exchange rate to rise.
Political stability
Countries with stable governments are safer places to invest and can attract more foreign direct investment. Governments can also influence the exchange rate through policies like currency intervention.
What is currency intervention?
- When a country has a high-demand currency, its exports become more expensive.
- The country’s central bank can lower the demand by buying other currencies.
- As demand for the country’s currency decreases, so does the exchange rate value. This makes exports more affordable.
However, these changes in the exchange rate can cause exchange rate risk, which means the possibility of financial loss due to exchange rate fluctuations. A currency’s exchange rate decrease would result in investments in that currency being worth less, creating financial losses for investors.
Economic growth
When a government introduces tax cuts or similar fiscal policies, it increases our spending. Increased public spending creates demand for goods and services, driving economic growth. Countries with strong economic growth attract foreign direct investment because they offer higher investment returns.
For example, if the British government reduces taxes, the public would have more money to spend on goods and services, making British businesses a potentially good investment. As investors would need GBP to invest, this would lead to a greater demand for GBP and would cause the exchange rate value to increase.
Trade
The balance of payments shows trade between countries, including imports and exports.
Suppose a country makes more money from exporting goods than it spends on imports. In that case, there is a higher demand for the country’s currency because more people need it to buy the exports. As a result, the currency becomes stronger and the exchange rate increases.
However, if a country has more imports than exports, the exchange rate decreases because there is a higher demand for the foreign currencies needed to buy the imports.
Central bank policies
Exchange rate volatility happens when a country’s exchange rate is constantly changing. To manage the risk, central banks can introduce policies known as currency hedging.
Currency hedging involves using financial contracts such as currency futures or currency options to protect against the fluctuations, helping central banks stabilise their currency’s value. Currency futures are contracts where buyers and sellers agree to trade the currency at a specific exchange rate at a later date. Currency options work the same way, only the contract holder can choose whether they want to do this.
Through currency hedging, central banks can manage currency risk and influence the exchange rate at later dates.
What are today's exchange rates?
If you’re travelling abroad and want to check today’s exchange rate, you can use our currency converter.
Understanding the value of another currency can be quite difficult, so it’s a good idea to regularly check the exchange rate to make sure you’re not being overcharged while abroad. Our holiday planning checklist comes with other useful tips to help you make the most of your holiday.
Published July 2023
