How Do Exchange Rates Work? All About Forex & More

What is an Exchange Rate?

An exchange rate is the rate at which one currency is exchanged for another currency. Exchange rates are determined by forces of supply and demand, which are in turn influenced by a number of factors.

Exchange rates are very important to trade and business since no country or business is a standalone entity – all countries engage in trade, and this exchange rate plays a very important role in the import and export of goods and services.

Understanding Exchange Rates

There are several factors that play a role in determining the value of any currency. Each currency’s value in turn determines its exchange rate. For example, you can buy 1 U.S. Dollar with 80 Indian Rupees, meaning that the exchange rate for the Indian Rupee in terms of the U.S. Dollar is 80.

The value of a currency is affected by so many wide-ranging factors that it becomes difficult to pinpoint which is the most influential.

Currency Trade

The currency market, also called forex, is a marketplace for investors to buy and sell currencies. This trade is done in pairs, where investors sell one currency and immediately buy another.

When investors see value in one currency, like the Indian Rupee, they will choose to buy more of it, sending its value up. On the other hand, to buy the Rupee, they have to sell another currency, sending the value of this currency down.

Currency trade is the biggest trading market in the world, with trillions of dollars of value being traded every single day. In the forex market, currencies are treated like company stocks or commodities, and investors gauge the value of the currency based on the

National Economy

Countries with stronger economies, flourishing trade and a stable GDP are likely to have a stronger currency with more value.

A strong economy is supported by political stability, trade surplus, a stable GDP, employment and many other positive factors.

The currency of these countries would be in high demand on the global market, sending its value high up. A good example of a strong economy with a high-valued currency is Switzerland.

The Swiss government and economic policies are amongst the most stable in the world. Switzerland also has a significant trade surplus, meaning they export more than they import. Swiss banks are known for secrecy laws and wealth management expertise, meaning the richest people in the world flock to Switzerland to store their money.

All these factors contribute to making the Swiss Franc a safe-haven currency, meaning people invest in the Swiss Franc in times of economic turmoil, making it a much stronger currency.

Conversely, countries with a trade deficit, unstable governments and policies typically have weaker currencies with low value.

Global Economy

Global macroeconomic conditions play a very important role in determining currency values. Despite strong national economies, if the global economy is struggling, chances are that even the strongest currencies will face a drop in value.

For example, during the economic shutdown that was a result of the COVID-19 pandemic, many of the strongest, most developed economies faced significant disruptions.

Germany, one of the most developed, export-oriented countries, faced a drop in demand for exported goods and problems with the supply chain. Even though Germany has a robust manufacturing sector, it still depends on imported inputs for production – this was disrupted by the shutdown.

All these factors lead to unemployment, inflation, and economic uncertainty, which affected the value of the Euro. The value of the Euro against the U.S. Dollar reached a two-year low of 1.08 EUR/USD in mid-March 2020.

How do Exchange Rates Fluctuate?

Exchange rates fluctuate for a number of reasons, depending on the currency, the country’s economic conditions, and whether it is a free-floating currency or a fixed currency.

Free Floating Currency

A free-floating currency’s value is determined by market forces of supply and demand. These currencies are called self-correcting since they have the ability to adjust their exchange rates without any intervention.

Central banks can indirectly affect the value of free-floating currencies by changing monetary policy, but the value of these currencies is largely dependent on market participants who collectively contribute to the discovery of a currency’s fair value through their buying and selling activities.

The U.S. Dollar is a floating currency, its value being determined by the market forces of supply and demand.

Fixed Currency

A fixed currency’s value is tied to the value of another currency or a basket of currencies. The central bank of the country determined this fixed value and ensures that the local exchange rate of their currency stays tied to the fixed value by buying and selling its own currency on the foreign market.

An example of a fixed currency is the Nepalese Rupee, which is tied to the Indian Rupee. It is pegged at the value of रु1.60 = ₹1 since 1994. As the value of the Indian Rupee rises and falls, the Nepalese Rupee follows suit.

Fixed currencies are used to control inflation and unstable economies, and can be helpful in countries experiencing economic or political crises.

Effect of Exchange Rate on Businesses

The value of a currency and its exchange rate has significant impact across all sectors of the economy. Understanding how forex rates affect business, trade and the individual is important since money supports all these sectors.

No business is a standalone entity – most, if not all businesses rely on inputs from abroad for their production in one way or another.

The purchase of these foreign inputs is facilitated by the foreign exchange market. For example, a clothes manufacturer would import cotton fabric from India. Let’s say this clothes manufacturer, ABC & Co is based in South Korea.

ABC & Co would have to buy cotton from India in rupees. This means he would have to first exchange Indian Rupees for his South Korean Won; you can buy 15.66 South Korean Won with 1 Indian Rupee.

After exchanging Wons for Rupees, ABC & Co can now import cotton from India for his business. ABC & Co buys 100 rupees worth of fabric from an Indian cloth maker. This means he spent 1565 South Korean Won.

Now imagine if the South Korean economy deteriorates, and the value of the South Korean Won drops. Now, ABC & Co would have to pay more Won to buy 1 Rupee. Previously he was able to buy 1 Rupee with 15 Won, but now he has to pay 30 Won for 1 Rupee.

In this situation, ABC & Co would have to shell out 3000 Won for Rs 100 worth of fabric – he had previously paid only 1565 Won.

Exchange rates affect businesses by impacting the cost of importing production inputs.

What is FOREX?

The Forex market is the global exchange market for currencies. It operates 24 hours a day for 5.5 days a week and is the largest market in the world. Banks, companies, retail investors and governments buy and sell currencies on this market.

Forex trading gives high returns, but is equally high risk – and so it is advisable for investors to engage in forex trading with care.

Traders in the forex market bet for or against a currency, and choose to buy or sell that currency, thus affecting the price of that currency.

Foreign Funding for Businesses

In 2022, startups in India raised $26.8 billion – and $26 billion of this came from foreign funding. Foreign funding remains the biggest source of capital for startups in India!

If you’re a startup founder and you’re not sure how to get started with foreign funding, we’re here to help. RazorpayX Forex helps startups bring foreign capital to India with a team of experts, ensuring 100% compliance and transparency at every step.

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