Exchange rate

An exchange rate states the relative value of two currencies. A quotation such as USD/EUR = 0.92 means that one U.S. dollar exchanges for 0.92 euros; the first currency is the base currency and the second is the quote currency. Rates can also be expressed inversely, so the same relationship is approximately EUR/USD = 1.09. ¹

Commercial banks, foreign-exchange dealers, card networks, and money-transfer companies apply their own buying and selling rates. The difference between those rates is the bid-ask spread, while retail customers may also pay commissions or other fees. A published mid-market rate is generally a reference point rather than the exact rate received by a customer.

Exchange rates may be nominal or real. The nominal rate compares currency prices directly; the real exchange rate adjusts for differences in domestic price levels and is therefore more useful for assessing the relative cost of goods and services. ²

Floating exchange rates are primarily shaped by demand for currencies in trade, finance, and investment. Interest-rate expectations, inflation prospects, economic growth, political risk, commodity prices, and central-bank policy can all alter that demand. Currency markets operate globally and continuously during the working week, although liquidity and volatility vary across time zones. ³

Under a fixed or pegged regime, a monetary authority commits to maintain the currency near a stated value against another currency or a basket. It may buy or sell foreign reserves, change interest rates, or impose exchange controls to defend the target. A crawling peg adjusts the target gradually, while a managed float allows market movement but includes occasional intervention.

The balance of payments provides a wider accounting framework: current-account transactions, financial flows, and reserve changes together help describe pressure on a currency, though no single account mechanically determines its rate.

Depreciation makes a currency cheaper relative to others, tending to support exports and make imports more expensive; appreciation generally has the opposite effects. The size and timing of these effects depend on contracts, trade composition, business pricing, and the responsiveness of buyers and sellers. Imported energy, food, machinery, and intermediate goods can transmit a currency decline into domestic inflation. ⁴

Governments and central banks face trade-offs when managing exchange rates. Higher interest rates may attract capital and support a currency but can weaken domestic demand. Intervention can smooth disorderly movements, yet sustained defense of an unrealistic peg may exhaust reserves or require capital restrictions. The “impossible trinity” describes the difficulty of simultaneously maintaining a fixed exchange rate, unrestricted capital movement, and an independent monetary policy. ⁵

Exchange-rate risk affects more than currency traders. An exporter paid in foreign currency, a firm borrowing abroad, a migrant sending remittances, and a pension fund holding overseas assets may all gain or lose when rates move. Hedging instruments such as forwards, futures, swaps, and options can reduce exposure, but they introduce costs, collateral requirements, and counterparty or model risk.

Official rates and market rates can diverge sharply when a government restricts access to foreign currency or maintains multiple legal rates. Parallel markets may then emerge, complicating national accounts and creating incentives for arbitrage. ⁶

Purchasing power parity compares currencies through the prices of comparable goods, but transportation costs, taxes, non-tradable services, market segmentation, and productivity differences mean that actual exchange rates can depart from parity for long periods. Exchange-rate indexes address this by comparing a currency with several trading partners rather than with only one currency.

Base currency

The first currency in a quotation; one unit of it is valued in the quote currency.

Nominal exchange rate

The market price of one currency in units of another, without adjustment for price levels.

Real exchange rate

A relative-price measure that adjusts the nominal rate for differences in national price levels.

Peg

An official arrangement that keeps a currency near a specified value or range.

Bid-ask spread

The difference between the price at which a dealer buys a currency and the price at which it sells it.