How Is Exchange Rate Calculated

The exchange rate indicates as to how much of one currency has to be given for buying another. Exchange rates keep fluctuating continuously during the course of trading throughout the week. This makes the prices of currencies go up or down as in the case of other assets like stocks and gold. A currency’s market price (for example, the number of Canadian dollars required to buy one US dollar) is different from the rate at which your bank exchanges currencies with you. The aim of this article is to help you understand as to how the exchange rate works and find out for yourself if you are getting a good deal.

Market Exchange Rate

foreign currency exchange rate board with lighting hand in backgDuring the week, institutions and traders keep buying and selling the currencies for 24 hours in a day. A trade takes place only when one currency is exchanged for another. This is to say that in order to buy British pounds (GBP), for example, another currency is required to be given in exchange. You may use any currency, but together they form a currency pair. If you use US dollars (USD) to buy GBP, then the exchange rate denoted for the GBP/USD pair. Live rates for a number of currency pairs will be available to traders and investors.

How to Read an Exchange Rate

If the exchange rate of the USD/CAD pair is 1.0950, it means that you will have to shell out 1.0950 Canadian dollars to buy 1 US dollar. The first currency (in this case the USD) represents one unit of that currency. Therefore, the exchange rate tell you how much of the second currency (in this case the CAD) is required in order to buy 1 unit of the first currency.

Since the USD/CAD exchange rate only tells you as to how many Canadian dollars you have to give to buy 1 US dollar, you will have to use the formula 1/exchange rate in order to find out as to how many US dollars will be needed to buy 1 Canadian dollar.

In this example, it is 1/1.0950, which is equal to 0.9132. This means that it costs you 0.9132 U.S. dollars in order to buy 1 Canadian dollar. The CAD/USD pair indicates this price for you. You may notice that there is a switching of the position of the currencies.

Yahoo! Finance, for example, provides live market exchange rates for all of the currency pairs. If you want to find the market exchange rate for a currency that is very obscure, all you need to do is click on the “Add Currency” button and then type in the names of the two currencies whose exchange rate you want to know. You can find charts with live market exchange rates for most of the currency pairs at FreeStockCharts.com.

Conversion Spreads

If you go to a bank for exchanging a currency, you are not likely to get the market rates at which traders buy and sell currencies. The bank, or for that matter any of the currency exchange service providers, will not offer the market rates. They mark up the rates so that they are in a position to make some profit through the trade. Credit card providers and payment service providers like PayPal do the same thing when they exchange currencies.

If the price of the USD/CAD pair is 1.0950, then market price of 1 US dollar is 1.0950 Canadian dollars. However, the banks may ask you to pay 1.12 Canadian dollars if you want to buy a US dollar. This difference between a currency’s market exchange rate and the actual exchange rate charged by the exchange service provider is their profit. In order to calculate the discrepancy in percentage terms, find out the difference between the two exchange rates and then divide the difference by the market exchange rate. In this example, it is as follows:

1.12 – 1.0950 = 0.025/1.0950 = 0.023. Multiply the result by 100 to find out the percentage markup. Therefore, the percentage markup is 0.023 x 100 = 2.23 percent.

A markup will have to be paid when converting the U.S. dollars to Canadian dollars as well. The market exchange rate for the CAD/USD pair may be 0.9132, but the banks may charge you 0.9382 US dollar in exchange for 1 Canadian dollar. Here the markup is 0.9382 – 0.9132 = 0.025/0.9132 = 0.027 x 100 = 2.7 percent.

This is because banks and forex changers take a fee for the service they provide. Banks give you cash, but the traders do not deal in cash in the market. In order to obtain cash, traders will have to pay a withdrawal or processing fees or wire transfer charges at the time of transferring funds from their trading accounts to their bank accounts. Most people want cash immediately and, therefore, they have to pay a markup.

Therefore, the best thing you can do is shop around to get an exchange rate that is very close to the market exchange rate. This will help you to save you a little more money.

Calculating Your Requirements

If you need a foreign currency, then use the exchange rates and determine as to how much of the foreign currency you will need and how much of the local currency will be needed to buy the same.

For example, if you are traveling to Europe, you will need euros (EUR). If you have USD with you, then you need to find out the EUR/USD exchange rate offered by your bank. The market exchange rate for the pair may be 1.3330, but the bank quote 1.35 or more.

If you have $1000 with you, you may get 740.74 euros at the exchange rate offered by your bank. On the other hand, if you need to have 1500 euros when traveling to Europe, you will have to shell out $2025 at the bank’s exchange rate of 1.35.

The Bottom Line

The exchange rate determines the cost of one currency with respect to another. It is important to understand the order in which the currency pairs are listed. Always, the first currency is expressed in terms of one unit. The exchange rate indicates how much of the second currency is required to buy one unit of the first. Banks always levy a charge for the service they provide by marking up the exchange rate.

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