How Currency Exchange Rates Work
Learn the mechanics behind exchange rates, what causes currencies to strengthen or weaken, and tips for getting the best deal.
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What Determines Exchange Rates
Exchange rates are primarily driven by supply and demand in the foreign exchange market, commonly known as the forex market. It is the largest financial market in the world, with more than 6 trillion dollars traded every single day. When demand for a currency increases relative to its supply, its value rises against other currencies.
The Mid-Market Rate
The mid-market rate, also called the interbank rate or the spot rate, is the midpoint between the buy and sell prices in the forex market. It represents the fairest possible exchange rate at any given moment, and it is what you see displayed on Google, financial news websites, and currency comparison services. However, when you actually exchange money through a bank, airport kiosk, or online service, you will not get the mid-market rate. These services add a markup called the spread, which is how they make their profit.
Getting the Best Exchange Rate
The single most important rule is to avoid airport exchange counters whenever possible. They consistently offer the worst rates because they know travelers are in a hurry and have limited alternatives. Using your bank's ATM network abroad is often a much better option for getting cash, though you should check with your bank first about foreign transaction fees and daily withdrawal limits. Credit cards that charge no foreign transaction fees typically provide exchange rates very close to the mid-market rate, making them one of the best options for purchases abroad. Before exchanging a large amount of currency, compare rates from multiple providers. Even a 1 percent difference in the exchange rate adds up to significant savings on a large transaction.
Fixed vs Floating Exchange Rates
Most major world currencies, including the US dollar, euro, British pound, and Japanese yen, use floating exchange rates, meaning their values are determined by market forces and fluctuate continuously throughout the trading day. Some countries, however, choose to peg their currency to another currency at a fixed rate.
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