How Currency Exchange Rates Work

Whether you are planning an international trip, sending money abroad, importing goods for your business, or investing in foreign markets, understanding currency exchange rates helps you make smarter financial decisions. The foreign exchange market is the largest financial market in the world, with the Bank for International Settlements reporting daily turnover exceeding $7.5 trillion as of 2022. This guide explains how rates are set, what causes them to change, and how to minimize costs when converting currencies.

What Are Currency Exchange Rates?

A currency exchange rate is the price of one currency expressed in terms of another. When you see "EUR/USD = 1.08," it means one euro costs 1.08 US dollars. The first currency listed (EUR) is the base currency, and the second (USD) is the quote currency. The number tells you how much of the quote currency you need to buy one unit of the base currency.

Exchange rates can be quoted in two ways:

• Direct quote: How much of your domestic currency is needed to buy one unit of foreign currency. For a US resident, USD/EUR = 0.93 means one dollar costs 0.93 euros.
• Indirect quote: How much foreign currency one unit of your domestic currency can buy. For a US resident, EUR/USD = 1.08 means one euro costs $1.08.

The distinction matters when performing conversions. If you are traveling from the US to Europe and need euros, you want to know how many euros your dollars will buy (indirect quote perspective). If you are a European business paying a US supplier, you want to know how many euros you need per dollar (direct quote perspective).

How Exchange Rates Are Determined

Floating Exchange Rates

Most major currencies — including the US dollar, euro, Japanese yen, British pound, and Australian dollar — operate under a floating exchange rate system. Their values are determined by supply and demand in the foreign exchange (forex) market. When demand for a currency increases relative to supply, its value rises. When demand falls, so does its value.

Central banks may intervene occasionally to stabilize extreme volatility, but they do not set a fixed rate. The Federal Reserve, European Central Bank, and Bank of Japan all let market forces primarily determine their currencies' values while using monetary policy tools like interest rates to influence economic conditions indirectly.

Fixed and Pegged Exchange Rates

Some countries fix or peg their currency to another currency (usually the US dollar or a basket of currencies). For example, the Hong Kong dollar has been pegged to the US dollar since 1983, maintaining a narrow band around HKD 7.80 per USD. Saudi Arabia pegs the riyal to the dollar at approximately 3.75 SAR per USD.

Pegged currencies require the central bank to actively buy or sell its own currency in the forex market to maintain the fixed rate. This provides stability for trade but limits the country's ability to conduct independent monetary policy. If the peg becomes unsustainable due to economic divergence, it can break suddenly, causing dramatic rate shifts.

Factors That Drive Exchange Rate Fluctuations

Several fundamental forces cause exchange rates to move:

• Interest rate differentials: Countries with higher interest rates tend to attract foreign capital seeking better returns, increasing demand for that currency. When the Federal Reserve raises rates while the European Central Bank holds steady, the dollar typically strengthens against the euro.
• Inflation rates: Countries with lower inflation see their currencies appreciate over time because their purchasing power erodes more slowly. If US inflation is 2% and UK inflation is 5%, the pound tends to weaken against the dollar over time.
• Trade balances: A country that exports more than it imports creates demand for its currency (foreign buyers need it to pay for goods). Persistent trade deficits tend to weaken a currency because more of it flows abroad than returns.
• Economic growth: Strong GDP growth attracts foreign investment, boosting currency demand. Countries growing faster than their peers often see their currencies strengthen.
• Political stability: Political uncertainty, elections with unpredictable outcomes, or geopolitical tensions can trigger capital flight, weakening the affected currency.
• Central bank policy: Forward guidance, quantitative easing, and rate decisions directly affect currency values. A hawkish central bank (signaling rate increases) tends to strengthen its currency.
• Market sentiment and speculation: Large institutional traders, hedge funds, and algorithms account for most forex volume. Their expectations about future events move rates before the events occur.

Understanding the Bid-Ask Spread

When you exchange currency, you never get the exact mid-market rate. Instead, you encounter a bid-ask spread:

• Bid price: The rate at which the exchange service buys the currency from you (lower number).
• Ask price: The rate at which the exchange service sells the currency to you (higher number).
• Spread: The difference between the bid and ask, which represents the exchange service's profit margin.

For example, if the mid-market rate for EUR/USD is 1.0800, a bank might quote a bid of 1.0700 and an ask of 1.0900. If you are buying euros with dollars, you pay the ask price of 1.09 per euro instead of 1.08. On a $1,000 exchange, this 1% spread costs you roughly $9. Airport kiosks often have spreads of 5% or more, making them the most expensive option.

How to Convert Currencies

Currency conversion uses simple multiplication or division depending on the direction:

Practical Examples

The difference between providers is dramatic for remittances. Over a year of monthly $500 transfers, choosing the online service over the bank wire saves roughly $5,820 PHP (about $100) in spread costs alone.

Where to Exchange Currency

Not all exchange venues are created equal. Here is a comparison from best to worst rates:

1. No-foreign-transaction-fee credit cards: These use rates very close to the mid-market rate with zero markup. Best for purchases at your destination. Cards from major issuers often waive the typical 3% foreign transaction fee.
2. Online currency exchange services: Dedicated services like Wise (formerly TransferWise) offer rates close to mid-market with transparent, low fees. Ideal for larger amounts and international transfers.
3. Bank ATMs at your destination: ATMs in the local banking network generally offer competitive rates. Check if your home bank reimburses international ATM fees or has partner banks abroad.
4. Your home bank branch: Ordering foreign currency from your bank before travel is convenient but rates are typically 2-3% above mid-market.
5. Currency exchange counters (malls, cities): Rates vary widely. Shop around and always ask for the total cost including fees before committing.
6. Airport and hotel exchange desks: Consistently the worst rates, often 5-10% above mid-market. Use only as a last resort for small amounts.

Tips for Getting the Best Exchange Rate

• Always decline dynamic currency conversion. When a foreign ATM or card terminal offers to charge you in your home currency, decline and pay in the local currency. The conversion rate they apply almost always includes a 3-7% hidden markup.
• Compare the offered rate to the mid-market rate. Check Google, XE, or our currency calculator for the current mid-market rate. Any difference is the provider's markup, and now you can make an informed decision.
• Avoid exchanging at the airport. Airport exchange services have a captive audience and charge premium rates. If you must exchange at the airport, limit it to a small amount for initial transportation costs.
• Use a no-foreign-transaction-fee card for purchases. For everyday spending abroad, this is almost always the most cost-effective option. Many travel credit cards also offer rewards points on international purchases.
• Time large transfers strategically. If you need to make a large currency conversion and the exchange rate is unfavorable, consider splitting it into multiple smaller transfers over weeks. This averages out short-term fluctuations, a strategy known as dollar-cost averaging applied to forex.
• Watch for hidden fees. Some services advertise "zero commission" but make up for it with terrible exchange rates. Always calculate the total cost: the amount you send minus the amount the recipient gets equals your true cost.

Major World Currencies Reference Table

Note that forex volume percentages sum to 200% because each trade involves two currencies. The US dollar is involved in approximately 88% of all forex transactions, making it the world's dominant reserve and trading currency.

Last updated: February 23, 2026