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How Do Currency Exchanges Work?

Updated August 17, 2021 | Paul Kersey

How Do I Exchange Currencies?

If you ever travel overseas you will want to exchange some of your money for foreign currency. Or be ready to pay for a bill that is listed in something other than US dollars. But how do you get the currency you need? And how do we decide how much a British pound or a Japanese yen is worth? That is all worked out through the foreign exchange markets.

How Currency Converters Work

The foreign exchange system is a network of markets in which various currency pairs are traded back and forth: Mexican pesos for British pounds, euros for Indian rupees, Chinese yuan for Japanese yen, American dollars for Canadian dollars. The leading players in these currency markets are banks, which hold some of their reserves in various foreign currencies for their customers. Financial firms, such as insurance, investment, and credit card companies, will also participate in currency exchanges. The US dollar and the euro are the most commonly traded currencies.

The vast majority of currencies around the world will "float," meaning that their value is determined in the marketplace with little if any interference from the governments that issue them. The value of one currency can shift from day to day.

It wasn't always like this. After the Second World War the "Bretton Woods" system of currencies established firm exchange rates. In theory, the US dollar's value was pegged to gold, and all other currencies' values were pegged to the dollar. Nations could adjust the value of their currencies, but large shifts required the approval of the International Monetary Fund. (IMF)

The United States and its allies created this system to provide stability and predictability. Merchants could buy and sell overseas without fear of large shifts in currency costs. But the system broke down in 1971 when the United States announced it could no longer retain the dollar's tie to gold. This made the dollar a "fiat currency," whose value floated. Inevitably all currencies were allowed to float.

The foreign exchanges (FOREX, for short) are simply a network of major financial institutions that are constantly trading currencies, adjusting prices as demand for different currencies ebbs and flows. The markets may slow down over the weekend, but during the week different banks around the world will trade currencies around the clock.

How Are Currencies Priced?

The currency markets are affected by many things, but the most important factor is probably the most common-sensical: how much things cost in different countries, also known as purchasing power. Measuring purchasing power can be tricky. Consumers in different countries will buy different goods and services, and different materials may be harder to get, affecting the costs of individual items.

Purchasing Power Parity and the Big Mac Index

For instance, The Economist, a British magazine, maintains what it calls the "Big Mac Index." They estimate purchasing power by tracking the price of the famous McDonalds hamburger, on the theory that a standardized meal with ingredients that can be found around the world would make a good, simple indicator.

In theory, once exchange rates are accounted for the cost of a Big Mac should be the same around the world. But the price of the burger can vary. After converting everything into dollars, a Big Mac in Switzerland can cost half again what it costs in the US and three times as much as it would in Ukraine. So, the matchup is far from perfect. Other things can affect exchange rates.

Inflation

People and companies don't instantly spend the money they have. They usually try to save some of it. But if your local currency is prone to inflation, you might want to put a more stable currency in your savings account instead. This tendency will tend to pull down the value of your local money.

Interest Rates

If Chinese bonds are paying a higher interest rate than American bonds, investors will want Chinese yuan to buy those bonds, regardless of what the purchasing power parity is. The yuan will gain value against the dollar.

Governmental Stability

If your national government is seen as unreliable, investors and savers will probably want to hold on to the currency of some other nation to avoid the economic risks that come with war, revolution, or severe inflation. That will lower the value of the local currency, even if its purchasing power is solid and inflation is low.

How to Buy Foreign Currency

Buying foreign money is relatively easy. The trick is to make sure you are getting a reasonable rate on the exchange. Currency exchanges will want to make at least a modest profit on the trade. This is only reasonable because they found a seller with the currency for you and are accepting the risk of holding foreign funds. But you don't want to give up more than necessary.

Before traveling, be sure and look into how the local economy works, and in particular whether merchants, restaurants, and transit systems have a preference for cash or credit cards. You will want to have at least a little bit of local money with you or buy some shortly after you arrive for small purchases, but knowing the customs will help you decide just how much you really need.

You will also want to know the latest currency exchange rates, both buying and selling, so you have a sense of what to expect and can get a fair trade. These can be found online.

Below are the three-letter codes typically used for some of the most heavily traded currencies:

USD: US dollar

EUR: euro (which took the place of the French franc, German mark, Italian lira, and other European currencies in 2002)

GBP: British pound (also known as the pound sterling)

JPY: Japanese yen

CNY: Chinese yuan (also known as renminbi)

CAD: Canadian dollar

AUD: Australian dollar

CHF: Swiss franc

MXN: Mexican peso

INR: Indian rupee

Most travelers will advise you to avoid the currency exchange booths at the airports; their conversion rates tend to be skewed against you, and they may charge handling fees as well. You may be better off buying through your hometown bank, because they are much less likely to charge additional fees.

One option is to find an ATM operated by your bank or an affiliate when you land at your destination. They will have the local currency in stock, so the rate should be reasonable, and because you are working through your own bank or a partner, you shouldn't need to worry about ATM fees.

Conclusion

The foreign currency markets may seem a bit intimidating, but they don't have to be. A little research and preparation can make them a lot easier to navigate. And while it might take time to get used to prices quoted in a new currency, most national currencies are stable, and prices are predictable enough for you to make sense of how much things cost, and what is a good bargain for your money, whether you're carrying euros, yen, pounds, or good 'ole greenbacks.