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 to work out exchange rates you will be able to help your money go further for you and your loved ones.
In this blog we’ll explore a number of topics concerning exchange rates so that you can develop a complete understanding. These topics include:
- What do we mean by “Exchange Rate”?
- Floating and fixed rates
- Who decides the exchange rates?
- What factors affect exchange rates, and how?
- 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 Nigeria, what would this mean? Well, on the 24th of February 2021, the exchange rate was 1 GBP to 540.63 NGN. This means that you would have been able to buy 540.63 NGN 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 the United States, Singapore and the United Kingdom have strong 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.
Floating and fixed rates
Most nations have floating (or flexible) exchange rates that change on a minute-by-minute basis. Floating exchange rates are one of the reasons you need to be educated 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.
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.
Who decides the exchange rates?
What determines exchange rates? Who decides the exchange rate of dollars to pounds? 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.
What factors affect exchange rates, and how?
How much your country’s currency is worth is mainly based on the demand for that currency. Therefore, the demand for a currency can depend on what’s happening in that country at any given time.
- 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 it’s 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.
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 February 3rd, 2021 was 1 GBP = 218.43 PKR.
- Using this exchange rate you would be able to buy 218,420 PKR with £1,000.
- Just 20 days later, on February 23rd, 2021, the exchange rate was 1 GBP = 224.30 PKR.
- Using this exchange rate you would be able to buy 224,300 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. Register with Small World in just a few simple steps and start sending money today.
Your first transfer online is always free of fees!