Part 1 - How FX Rates Are Set: A Quick Guide

Part 1 - How FX Rates Are Set: A Quick Guide

Sell your products or services to foreign customers?

If you do, you’re probably losing a chunk of your profits without realising it.

A Money Mover study reckons international trade is worth £700 billion a year to UK small and medium-sized businesses. But between 3% to 6% of that — a massive £42 billion — is lost to foreign exchange fees. Worse, 80% of SMEs don’t even know how much their bank is charging for foreign transactions.

With this in mind, we’ve put together a quick, two part, straightforward guide to exchange rates. In Part 1 of the article, we’ll cover:

  • What exchange rates are; and
  • How they’re set

What’s an FX rate?

An FX rate or exchange rate tells you how much a currency is worth compared to another. So, if the exchange rate from British Pounds to Euro is 1.178, for instance, that means £1 is worth approximately €1.18.

There are three main types of exchange rate:

  • Floating
  • Fixed
  • Managed

What is a floating exchange rate?

Major currencies such as the US Dollar, British Pound, and Euro have floating exchange rates. This means their value — and, so, their exchange rates — go up and down in accordance with the laws of supply and demand.

When a currency’s exchange rate goes down, it’s cheaper to exchange to it. By contrast, a higher exchange rate means exchanging costs more.

When does the exchange rate go down?

The exchange rate usually goes down when:

  • A currency’s supply increases. This can happen, for example, when a country’s central bank lowers interest rates. With lower interest rates, more people take out loans, because borrowing is cheaper. And more borrowing means more money in circulation
  • Demand for the currency is low. This can happen if fewer people are borrowing or investing, for example because the country is facing political or economic uncertainty

When does the exchange rate go up?

The exchange rate usually goes up when:

  • A currency is in short supply. This can happen if, for instance, the central bank decides to raise interest rates. Higher interest rates make borrowing more expensive. In turn, fewer people take out loans and there’s less money in circulation
  • A currency is in demand. Let’s say you decide to expand your business to the US. You’ll need US Dollars to pay utilities, salaries, and other startup costs. The more businesses have that same idea and decide to invest in the US, the higher the demand for US Dollars will become, which will drive up its exchange rate

What is a fixed exchange rate?

A fixed exchange rate is the opposite of a floating exchange rate. Instead of fluctuating in accordance with supply and demand, a fixed exchange rate is set by the government and kept more or less the same in one of two ways:

  • Pegging
  • Controlling supply and demand

What is currency pegging?

Pegging means fixing the currency’s value to that of:

  • One stronger currency
  • A basket of currencies. This is called a basket peg

The Saudi Arabian Riyal, for instance, is pegged to the US Dollar. When the US Dollar’s exchange rate goes up, the Saudi Arabian Riyal’s exchange rate also goes up. And when the US Dollar’s exchange rate goes down, the Saudi Arabian Riyal’s exchange rate goes down too. The exchange rate between the Dollar and the Riyal is always the same, because of the peg.

How countries control supply and demand

The other way a fixed exchange rate stays constant is through government intervention. The government can control supply and demand in one of three ways:

  • By raising or lowering interest rates. This makes borrowing more or less expensive
  • By buying or selling foreign currency. This can make it look like there’s greater demand for that currency, which increases its value. Or it can flood the market with that currency, decreasing its value
  • By placing restrictions on who can buy or sell the country’s products and services and who can invest. Restricting imports, exports, and investment lowers demand for currency, decreasing its exchange rate

What is a managed exchange rate?

A managed exchange rate is mid-way between fixed and floating.

Typically, the government will let the currency fluctuate, but only up to a point. If the exchange rate risks going too low or too high, it intervenes.

The Chinese Yuan is one example of this type of approach.

In Part 2 of the series on FX rates, we are going to talk about:

  • How banks typically charge you for international transactions
  • Most importantly, how you can get the best rate so you can keep more of your profits

Want to boost your international sales without burning a hole in your profits?

Talk to us today.

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