You will have heard the term exchange rate before. You may even have some idea of what it means. But, if you’re someone who transfers money internationally you’ll want to have a complete understanding because exchange rates are very important.
Why? By knowing how exchange rates are determined and why they sometimes fluctuate you will be able to help your money go further for you and your loved ones.
In this blog, we’ll highlight a variety of topics to do with determining exchange rates. These topics include:
- What do we mean by “Exchange Rate”?
- Determining floating and fixed rates
- Why do currencies fluctuate?
- How do currency rate fluctuations affect financial statements?
- Who decides the exchange rates?
- Is a higher or lower exchange rate better?
What do we mean by exchange rate?
In short, an exchange rate is how much the currency of one country is worth compared to the currency of a different country or economic zone.
Let’s look at a simple example:
If you were living in the UK and you wanted to send money to Pakistan, what would this mean? Well, on average during 2022 the exchange rate between the British Pound and the Pakistan Rupee has been hovering around 1 GBP to 247 PKR. This means that you would have been able to buy 247 PKR with every one of your British pounds.
As well as being a direct way of buying and selling currency for those who are travelling or sending money overseas, the exchange rate is also used as a way of measuring a country’s economic health [Investopedia]. Having a strong exchange rate means that your country’s currency is valued well against other currencies around the world.
For example, countries like Switzerland, Singapore and the United Kingdom have strong currencies whereas countries like Iran, Sierra Leone and Indonesia have relatively weak currencies. If a country has a higher-valued currency this means that their imports are cheaper and exports are more expensive for other countries to buy. This means they make more profit when trading internationally.
Determining floating and fixed rates
Most countries have floating (or flexible) exchange rates that change on a minute-by-minute basis. The ever-changing nature of floating exchange rates is one of the reasons you need to know as much as possible about exchange rates before sending money internationally.
The majority of exchange rates are determined by the foreign exchange market, or “forex”, which particularly impacts the currencies most used by people in the US (such as: Mexican pesos, Canadian dollars, European euros, British pounds, and Japanese yen). [The Balance] More on the factors that affect these exchange rates a little later on.
The governments of some countries, like Venezuela, choose to use fixed exchange rates. These only change when the government says so and are often pegged to stable global currencies like the US dollar or the Euro. This means that their worth is directly linked to the worth of the stronger, stable currency. This is in contrast to countries like Pakistan who, since 1999, operate a market-based flexible exchange rate system.
Countries that are pegged to the dollar
Countries that are pegged to the Euro
These lists depict countries with fixed exchange rates but for the rest of this blog we’ll be looking primarily at floating exchange rates.
Why do currencies fluctuate?
There are many reasons for currency fluctuations but ultimately it is often related to the simple economic principle of supply and demand.
In countries like the US, the UK and Pakistan, their floating exchange acts just like a commodity and is therefore subject to change when levels of supply and demand fluctuate. For example, if there is high demand for the Pakistan rupee the currency will cost more compared to currencies that are in less demand.
Supply and demand for currencies is influenced by a variety of elements including the economic certainty and health within a country, interest rates, foreign investment, social or political upheaval and international trade. For many countries around the world these elements are constantly changing and therefore minor, and sometimes major, currency fluctuations have become a natural part of economic life.
According to The Balance and Economics Help, the main factors that affect exchange rates are:
- Interest rates: A higher interest rate makes that currency more valuable. Investors will exchange their currency for the higher-paying one. They then save it in that country's bank to receive the higher interest rate.
- Money supply: If the government prints too much currency, then there's too much of it chasing too few goods. Currency holders will bid up the prices of goods and services which can create inflation. If too much money is printed, it causes hyperinflation. How does inflation affect exchange rates? Well, a country with consistently low inflation rates will have a strong currency value because its purchasing power relative to other currencies will increase.
- Financial stability: If the country has a strong, growing economy, then investors will buy its goods and services. They'll need more of its currency to do so. If the financial stability looks bad, they will be less willing to invest in that country. They want to be sure they will get paid back if they hold government bonds in that currency.
- Speculation: If traders believe that the value of the pound will rise, they will demand more in order to make a profit. This demand will increase the value of the pound.
Pakistan’s currency fluctuations
For example, in 2022 Pakistan has been suffering from quite severe currency fluctuations brought about by a lack of foreign financing/investment alongside political, social and environmental unrest.
While the State Bank of Pakistan (SBP) said that the fluctuation in the rupee value was merely a feature of the floating market-based exchange rate system, the fluctuation was much more volatile than they would have liked.
In July 2022 the Pakistan Rupee had slumped to a record currency low of 230 against the US dollar. Inflation in Pakistan was at its highest in more than a decade. The situation has been made even worse by the devastating floods that have hit the region in August and September. Pakistan’s currency, which was already fluctuating wildly, will likely take a while to recover.
If you’re interested in what determines exchange rates and how the value of currencies can change quickly, Pakistan in 2022 provides a stark example of how many negative events all occurring at the same time can contribute to the rapid decline of a currency.
How do currency rate fluctuations affect financial statements?
If you run a company that does business overseas as well as at home or if you are planning on sending and receiving money internationally, then it is important to understand how currency rate fluctuations can affect your financial statements.
The key element to be aware of is Foreign Currency Translation Adjustments or Cumulative Translation Adjustment (CTA). These translation adjustments are tools that allow businesses and individuals to summarise the gains and losses caused by fluctuating exchange rates over time. If you don’t use these tools your financial statements may be inaccurate and misleading because they won’t take into account the differences between currencies.
By translating and understanding these currency rate fluctuations businesses can ensure that their financial statements are compliant and keep track of all incoming and outgoing funds.
Who decides the exchange rates?
For countries that use a floating exchange rate, the value of their rate depends on a variety of factors. It’s often assumed that currency exchange rates are fixed by banks, but this isn’t the case.
While the Bank of England is the UK’s central bank, it does not decide how much the pound is worth against other currencies [Bank of England]. However, it is worth noting that the Bank of England can impact exchange rates by:
- Adjusting an important interest rate called the Bank Rate (if the Bank Rate goes up, the pound becomes more valuable)
- Limiting inflation (keeping prices reasonable)
So, if it’s not The Bank of England, who decides how much the pound is worth?
As the Bank of England explains: “The exchange rate for the pound is decided by supply and demand, just as the price of a train journey is higher at peak times when more people need to travel, the pound gets stronger when people want to buy more pounds.”
Investors and “foreign exchange traders” all around the world buy and sell foreign currency every day. It’s these trades — based on what traders are willing to pay for different currencies that day — that decide the global exchange rates for the pound.
Banks, and money transfer companies like Small World, use these rates to decide how much our customers can buy and sell currencies for.
Is a higher or lower exchange rate better?
If you’re sending money abroad from the UK, you are using the pound to buy another currency. You are looking for a higher exchange rate. This way, you’ll get more of the foreign currency you’re buying [Foreign Currency Direct].
Let’s use Pakistan as an example:
- You want to send £1,000 home to Pakistan.
- The exchange rate on September 10th, 2022 was 1 GBP = 262.59 PKR.
- Using this exchange rate you would be able to buy 262,590 PKR with £1,000.
- Just 5 days earlier, on September 5th, 2022, the exchange rate was 1 GBP = 253.62 PKR.
- Using this exchange rate you would be able to buy 253,620 PKR with £1,000.
As you can see, a higher exchange rate is better, because the recipient will receive more rupees for the same amount of pounds.
Use Small World
The great thing about using Small World for your money transfer, is that we adjust our exchange rates. We keep a close eye on changes in the global market to ensure you get the best value for money.
Forget your currency converter! We compare rates, so you don’t have to. This means that you can always stay ahead of the game and avoid the consequences of any currency fluctuations. Register with Small World in just a few simple steps and start sending money today.
Your first transfer online is always free of fees!