Foreign Exchange (Forex) Rates: How Do They Actually Work?

In a perfect world, everyday items like an apple or a set of utensils should have the same price, regardless of your location. This concept is known as the law of one price (LOOP) — one item, one price, despite the currency exchange. But, the reality is that a currency conversion with zero slippage is not always possible.

The foreign exchange (FX) rate is a system that brings standardisation to international transactions. It enables the value of an item to be determined and expressed with consistency when different currencies are involved.

Correspondingly, it has a direct impact on an international business’ net earnings.

With globalisation facilitating the movement of goods, services and capital through borders, businesses are more outward-looking than ever, and it's created a climate where FX rates will play an ever-growing importance.

Understanding exchange rates

The exchange rate is a figure at which one currency can be exchanged for another currency in the same monetary system. The ‘rate’ displays how much one unit of a currency can be exchanged for the other.

Let’s break it down further with the EUR/USD, which is known as a currency pair. In every currency pair, the base currency is the first currency indicated, the EUR, and the quote currency is the one that follows, which is the USD.

At the time of writing, the exchange rate for the EUR/USD is 1.06. This means that one unit of Euro will cost 1.06 US dollars; 1 EUR = 1.06 USD.

With exchange rates, there are also direct and indirect pairs. Direct pairs, which indicate the amount of local currency required to purchase a single unit of foreign currency, designate the local currency as the base currency and the local currency as the quote currency, while it is the opposite for an indirect pair. So, for a person based in Europe, the USD/EUR is a direct pair, while the EUR/USD is an indirect pair.

As we have seen above, the EUR/USD is simply the two currencies placed alongside each other. Many other currency pairings are formed this way and include majors like the USD/GBP, SGD/IDR, HKD/EUR, or exotics like SGD/KRW.

How exchange rates fluctuate

Contrary to common belief, the FX rate for any currency is neither set nor fixed. Rather, it’s contingent on whether the currency has a floating exchange rate or a fixed exchange rate.

Floating exchange rate

A floating exchange rate is where the currency conversion is subjected to market forces of demand and supply on the foreign exchange market, or forex. For example, if demand for the JPY surges among Singaporean businesses, the price of the JPY in relation to the SGD would increase as firms sell SGD to acquire more JPY.

As Japan adopts a floating exchange rate for the yen, the Japanese government will not intervene by selling JPY to bring down the value of the yen, instead allowing market forces to determine its value.

Fixed exchange rate

With a fixed exchange rate, the central financial institution of a country sets or pegs its currency to a major world currency, and actively works to maintain the exchange rate by purchasing or selling both its own and foreign currencies.

Singapore adopts a fixed exchange rate for the SGD and the Monetary Authority of Singapore (MAS) manages the SGD against a trade-weighted basket of currencies. In 2019, MAS disclosed that it had purchased USD 29.9 billion of foreign currencies in intervention operations as part of its SGD-based monetary policy. This ensured that the SGD would maintain its value against other major currencies, as well as limit inflation.

Factors that influence exchange rates

While fixed and floating exchange rates are key determinants of a currency’s price, there are other factors that could impact its value at any given time.

Macro factors

Businesses, industries, and countries alike are subject to the macroeconomic factors within the environment they operate in. It’s no different for currencies and exchange rates. These include, among others, geopolitical tension, interest rates, monetary policies, and balance of trade.

Let’s consider the balance of trade, which represents the difference between a nation’s exports and imports. If, for example, there is an overwhelming demand for Japanese exports such that it exceeds the value of imports, importers will need to acquire more JPY to fund their purchases of Japanese goods, which in return creates a higher demand and value for its currency.

But what about when the currency is weak? With weaker currencies, the value of exported goods will be cheaper for purchasing countries. At the same time, it will increase the cost of imports as it must sell more of its currency to purchase foreign currencies, which will contribute to higher inflation as well.

Similarly, interest rates can be lowered or raised to make investments more attractive to foreign investors.

For example, assuming the standard interest rate across Southeast Asian banks is 2.5% and Singapore decides to raise it to 4%. This will spark a surge of demand among investors from Southeast Asian countries who are seeking a higher return on their money. As these investors sell their local currencies in exchange for SGD, the increased demand will push the value of the currency higher, thereby strengthening the currency in comparison to other currencies.

Forex and Commodities

The exchange rate of certain currencies is intertwined with specific commodities. However, it's often because a country is either a major supplier or consumer of that commodity.

One of the most prominent forex-commodity correlations is that of the Australian Dollar (AUD) and gold. Since Australia is a top exporter of gold, any movement in the commodity’s price will reflect similarly in the AUD’s value.

As an example, a rise in the price of gold would translate to a decrease in the USD/AUD pairing as the AUD gains value against the USD.

The same phenomenon can be observed with the Canadian dollar (CAD) and the price of oil, which moves in tandem — like the AUD and gold. As Canada is a major oil exporter, importers must purchase CAD to pay for Canadian oil, which ensures healthy demand for CAD.

Tallying the facts

Exchange rates can be influenced by several mechanisms, some of which are within the control of their respective governments. Typically, a trade surplus, political stability, and prudent fiscal policy represent the fundamentals of a high-value currency.

In contrast, failing to address inflation through fiscal policy can devalue currencies, translating to higher business expenses. Events like extreme weather phenomena can also reduce a nation’s harvests, affecting agricultural exports and dampening demand for their currency.

Above all, it’s important to keep in mind that no currency can retain its value indefinitely. Nations and businesses are constantly engaging with each other, and economic impacts affect all currencies at some point.

Better foreign exchange rates with Wallex

Currency prices are always changing, but the costly FX rates charged by traditional banks are guaranteed to eat into your transactions and contribute to higher business costs.

At Wallex, we personalise our rates to the unique needs of your business. If you are looking to make collections from customers or partners based overseas, Wallex provides you with a virtual account that is just like having a local bank account.

To make things even better, our multi-currency wallet enables you to make payments, collections, and FX conversions seamlessly.

Book a demo with us here or sign up for an account free of charge.