What is a Forex Rate?

Every financial instrument has a price denominated in a currency. But, the value of a currency doesn’t exist in a vacuum — it has to be compared against another currency.

The dissolution of the Bretton Woods monetary system in 1971 started an era of floating forex rates, opening the doors to speculation as well. This article will outline forex rates, show how to read them and define critical factors that impact their movement.

How Does a Forex Rate Work?

Currency quotes are always in pairs because when you buy one currency, you sell another and vice versa. Since the currency pair compares the value of one currency against another, it shows how much of the quoted currency it takes to buy one unit of the base currency. Initially, almost all the largest currencies traded with a peg, as they were tied to a fixed value. New currency (like the euro) usually launches at a pre-agreed value and then starts floating — letting the market decide its value daily.

How Do You Read Forex Rates?

The currency on the left is the base currency, while the one on the right is the quoted currency — therefore, the base currency is always fixed at one unit, while the quoted currency is floating.

For example, the USD/CAD rate of 1.3 shows us that it takes 1.3 Canadian dollars (quoted) to buy 1 U.S. dollar (base).

How Do I Calculate Exchange Rates?

Reading the currency rates is relatively straightforward when it comes to the base currency, but it takes a calculator for reversing the pairs.

In the example above, if you wanted to find out how much USD you can get for 1 CAD, you’d have to divide 1 CAD by 1.3 to find out you’d get 0.769 USD. An easy way to remember is that you multiply across left-to-right and divide across right-to-left.

Is a Higher or Lower Exchange Rate Better?

This question strictly depends on who you ask. The exchange rate makes no difference for traders since they’re only looking for volatility. However, for import/export companies, this rate is vital for their business operations as currency fluctuations can significantly impact their profitability. Therefore, companies often use forward contracts to protect themselves from such scenarios.

6 Factors That Influence Exchange Rates

Since currencies facilitate foreign trade, many factors influence their value. Consider the following fundamental factors and remember — since currencies trade in pairs, these factors can come from either side.

Interest Rates

Interest rates have the largest impact on currency value since they control the amount of money in the economy. When the central bank changes the interest rate, it changes the rate at which commercial banks lend money to each other to meet their reserve requirements. If this rate is higher, these lending operations become more expensive. Commercial banks pass that cost onto consumers through the higher cost of borrowing. Raising the rates makes a currency scarce while lowering the rates makes it more available.

Inflation

Inflation is an erosion of a currency’s value caused by supply shortage (cost-push) or excess demand (demand-pull). Cost-push is the decrease in the aggregate supply (e.g., European energy prices). On the other hand, demand-pull inflation is an increase in aggregate demand (e.g., graphic cards in 2021). Inflation is closely tied to interest rates since its manifestation in the economy prompts policymakers to raise interest rates in an attempt to control it.

Economic Performance

Gross domestic product (GDP) is the most fundamental indicator of economic performance — measuring the market value of all goods and services produced and sold in a specific time period. GDP data and projections are released quarterly, with higher-than-expected data being positive and lower-than-expected data being negative for the currency.

Current Account Deficits

The current account is the record of a nation’s global transactions that considers net trade in goods and services, net earnings on cross-border investment and net transfer payments. This balance can be positive (a surplus) or negative (a deficit). Countries with positive balances are regarded as creditors or lenders, while those with negative ones are borrowers.

Public Debt

According to a study by McMillin and Koray, higher public debt means higher interest rates because of higher default risk. However, there are exceptions. It might not be a problem for countries with debt denominated in their currency. Examples include the U.S. dollar (the world’s reserve currency) and the British pound. Yet, for emerging markets whose debt is often denominated in one of the larger currencies, this can be troublesome as they practically hold a short position on that currency with their debt. They have to keep paying more for debt every time that currency strengthens.

Terms of Trade

Terms of trade (TOT) is the ratio between a country’s export and import prices. This ratio is calculated by dividing the price of exports by the price of imports and then multiplying by 100. TOT measures the number of imported goods an economy can purchase per unit of exported goods. When TOT is greater than 100, it means that the country is exporting more than it imports. When the revenues from exports are higher, the demand for its currency increases, increasing its value.

Forex is Here to Stay

Forex has been one of the best markets to trade. Running 24 hours per day, 5 days per week — its diversity and size have been captivating traders and analysts.

Unlike other financial instruments, the forex market consists of pairs that trade as a ratio — as that is the only way of expressing the value of another currency. Thus, every forex pair falls under the influence of developments in two different economies. That influence is the source of volatility that makes forex trading so attractive. Using a quality broker is the first step on that journey, but ultimately, success in forex comes down to discipline and dedication.

Take the Next Steps to Trade Currency

Forex trading is lucrative but hard, especially without a reliable broker — an intermediary that executes trades on your behalf. The following lists contain Benzinga’s favorite forex brokers.

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