If you’ve ever transferred money overseas, you know how important it is to understand a country’s local currency and how it relates to the money you have. This is the idea behind how to calculate exchange rates and understand foreign currencies.
“Exchange rate” is an expression of the value of a currency relative to another, or how much of one currency you can trade for a different currency. For example, you could trade 1 AUD for about 55.80 INR. Or in reverse terms, 1 INR is equal to about 0.018 AUD.
How are exchange rates calculated?
Exchange rates are determined by foreign exchange trading (forex trading). Forex trading is an international market for buying and selling currencies, and it’s about 25 times larger than all the world’s stock markets.
Forex trading includes small transactions, like when you travel internationally and exchange your currency for the local currency. It also includes large transactions, like when a business purchases a significant amount of a given currency at an agreed upon exchange rate and at an agreed future date. Forex trading happens all day, every day, and that’s why the exchange rate is always changing for most currencies.
These trades impact exchange rates because there is more money circulating in different economies. Since about 88% of the world trade is in US dollars, most exchange rate calculations are compared to this currency.
What are the different kinds of exchange rates?
There are two different kinds of exchange rates to be aware of around the world: flexible and fixed exchange rates.
Flexible exchange rates
Flexible exchange rates are used to value the currencies of many developed countries, and they change depending on the balance between a currency’s current supply and the market demand, or need, for it. With a flexible exchange rate, if the demand for a currency is low and its supply is abundant, its value will decrease. The opposite is true for a currency in high demand/low supply. Since this cycle happens often, a flexible exchange rate is always changing.
A country employing a flexible exchange rate to its currency will also, in general, refrain from actively fixing or closely regulating the exchange rate. Instead, the forex market influences the exchange rate. For example, as of April 2021, the exchange rate was 1 AUD to 55.80 INR, but at the end of March 2020, it was about 1 AUD to 46.38 INR.
Fixed exchange rates
Fixed exchange rates are set and maintained by a country’s government, resulting in an official exchange rate. This set price is usually determined against the value of a major international currency, like the US dollar, or a ‘basket’ of multiple commonly traded currencies (i.e. US Dollar British Pound, Japanese Yen, etc.).
For a fixed exchange rate to work, the central bank buys and sells currency on the forex market in return for the currency(ies) it is compared against. For example, if a country fixes their exchange rate equal to 2 USD, they then must purchase enough US dollars to justify that exchange rate. These reserves are called foreign currency reserves and help regulate market fluctuations, inflation, and deflation, and as a result, the country’s exchange rate.
As of February 2021, countries with a fixed exchange rate include Saudi Arabia, Belize, Cuba, Hong Kong, Panama, United Arab Emirates, and many others.
What factors affect exchange rates?
One of the most common questions about exchange rates is “why do exchange rates change so frequently?” This is because they depend on several factors, such as interest rates, money supply, money demand, and the general financial stability of the host country.
Interest rates, inflation, and exchange rates are closely related because they directly influence each other. When financial institutions change the interest rate, this impacts currency values. Higher interest rates mean that lenders receive a higher return compared to other economies, which then motivates them to spend more money in that country. This leads to an influx in foreign capital, which causes the exchange rate to increase.
Decreasing interest rates have the opposite effect. As interest rates go down, so do exchange rates. In short, higher interest rates make a country’s currency more valuable, which drives investors to exchange their local currency for the higher-paying one.
Money supply, or how much cash a country has on hand, influences both inflation and exchange rates. This is the money that the country’s central bank creates. If there is too much money in circulation, this causes inflation. This also means that the country’s currency isn’t worth as much because there is more of it.
When that currency is exchanged internationally, it’s not worth as much because there’s an excess, resulting in a decreasing exchange rate. This is what economists mean when they talk about how “strong” a currency is.
The country’s economic health plays a role in determining its exchange rate. If a country has a strong economy, people will buy its goods and services. This results in more international currency being injected into the local economy. On the flip side, things like financial instability or political turmoil can make international investors nervous and they may move their capital to more stable countries.
How to read an exchange rate
Currency conversion calculations are presented in pairs, which means that one currency is quoted against the other. With currency pairs, the first currency listed stands for a single “unit” of that currency, while the exchange rate shows how much of the second currency you need to buy a unit of the first currency.
For example, if the AUD/INR currency pair is 55.80, that means it costs 55.80 Indian Rupees for one Australian dollar.
How to calculate exchange rates
Here is a step-by-step guide on how to calculate exchange rates:
1. Know the country’s exchange rate. You can find this information online or, if you’re traveling, exchange rates are usually posted at places like banks, airports, or currency exchange shops.
2. If you know the exchange rate, divide your current currency by the exchange rate. For example, suppose that the AUD/INR exchange rate is 55.80 and you’d like to convert 100 AUD into INR.
To accomplish this, simply multiply the 100 by 55.80 and the result is the number of INR that you will receive: 5,580 INR. Converting INR to AUD involves reversing that process. Using the same example, if you took your 5,580 INR and divided it by 55.80, you end up with 100 AUD.
3. If you don’t know the exchange rate, you can use the following currency conversion calculation to find it:
Starting Amount (Original Currency) / Ending Amount (New Currency) = Exchange Rate
For example, if you exchange 100 AUD for 5,580 INR, the exchange rate would be 0.018.
How much does it cost to send money abroad with Western Union?
It’s important to understand exchange rates, especially if you’re sending or receiving money from overseas, in addition to knowing how much your money transfer method will cost you. This gives you an idea of how much money will be received on the other end after the exchange rate and fees are applied.
Unfortunately, some money transfer services aren’t always transparent when it comes to fees and you may feel unsure about sending money. Thankfully, with Western Union, there’s no mystery and you can easily get an estimate for the cost of your money transfer. When you start sending money, fill out the applicable fields to get an estimate before you complete your transfer.