DEFINITION: The phrase “exchange rate” refers to the rate at which one national currency can be traded for another.
The exchange rate influences international trade and therefore the flow of money across national boundaries.
Exchange rates are influenced both by the value of the domestic currency and by the value of the foreign currency.
As an example, as of September 6, 2023 (the date of this writing), the exchange rate between the € (euro) and the $US (US dollar) stood at 1/1.07, meaning that one euro would purchase about $1.07.
Expressed the other way around, the exchange rate between the $US and the € stood at 1/.93, meaning that one dollar would purchase about 93 euro cents.
ETYMOLOGY: The English phrase “exchange rate,” or “rate of exchange,” is attested from the early eighteenth century.
The English noun “exchange” derives, via Middle English exchaunge, from Middle French eschange, which is connected to the verb eschangier, meaning “to exchange.” The latter verb derives from Vulgar Latin excambiare, also meaning “to exchange.”
The English noun “rate” is attested from the fifteenth century. It derives, via Middle English and Middle French, from the Medieval Latin adjective rata, which itself derives from the phrase pro rata (parte), meaning “according to a fixed proportion.”
The latter phrase, in turn, derives from classical Latin. The modifier rata is the past participle of the deponent verb reor, rēri, meaning “to reckon.” For further details, see the Etymology for the Glossary entry, “pro rata.”
USAGE: The value of a nation’s currency at any given point in time depends upon various economic factors. Among these are the gross domestic product (GDP), interest rates, and the unemployment rate of the countries whose currencies are to be exchanged.
These rates, often referred to as “market exchange rates,” are established within the global financial market, where banks and other financial entities engage in continuous currency trading influenced by the variables just mentioned.
Frequent fluctuations in exchange rates may result, ranging from minor adjustments on a daily, or even hourly, basis, to substantial changes over longer time periods.
In financial contexts, exchange rates are often discussed using three-letter abbreviations that represent the respective national currencies. For example, “USD” stands for the US dollar, and “EUR” signifies the euro.
When expressing the exchange rate between the US dollar and the euro, it is represented as EUR/USD.
Exchange rates can assume one of two primary forms: free-floating or fixed.
A free-floating exchange rate fluctuates on the foreign exchange market in response to market dynamics.
A fixed exchange rate is linked to the value of another currency.
For example, the Hong Kong dollar maintains a fixed exchange rate pegged to the US dollar, being allowed to fluctuate only within a narrow, specified range (7.75 to 7.85). Consequently, the value of the Hong Kong dollar will remain confined within this narrow window of price variation in relation to the value of the US dollar.
Exchange rates are characterized by two key values: the “spot rate,” also known as the “cash value,” and the “forward rate.”
The spot rate represents the current market value of a currency.
In contrast, the forward rate of a currency refers to its value on a parallel market, where a currency’s price is determined by traders’ anticipation of the likelihood of the future rise or fall of the currency’s value in relation to its spot rate (its general market value).