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What is a Foreign Currency Exchange Rate?

Carol Francois
Carol Francois

A foreign currency exchange rate is the amounts of one currency required to purchase or sell another currency. Every nation of the world has an official currency in which they conduct business. The exchange rate is calculated on a daily basis, based on the results of foreign currency trading activity for the day.

There are two different methods of calculating the foreign currency exchange rate: direct and indirect. A direct rate is also known as a multiplier. This value is multiplied by the target currency to determine the value of the currency in another currency.

Various types of currency, including US dollars, pounds sterling, and euros.
Various types of currency, including US dollars, pounds sterling, and euros.

For example, in order to exchange an English pound into US Dollars, two steps must be followed. First, obtain the direct exchange rate from a bank or foreign exchange company. Multiply the rate by the amount required in US Dollars. This value is the amount of English pounds required. When looking at a direct exchange rate table, it is always read from left to right.

An indirect foreign currency exchange rate is also known as a divider. The daily posted rate is provided based on one specific currency, and all values are based on the valuation of a third currency. Therefore, the rate must be divided by the daily rate for the third currency to obtain the actual amount required in the home currency to purchase the secondary currency.

The foreign currency exchange rate is based on trading that is done on the foreign currency exchange. Governments, banks, and large companies regularly hold other countries currency as an investment. They buy and sell the currency based the latest information on that counties economy, political stability, and economic forecasts.

The rate used by consumers for purchases and travel is known as the market rate, and is based on the trading completed the previous day. Whatever the currency was selling for at the close of trading the previous day is the rate for next business day. However, this rate is only available when trading in currency. Most banks and financial companies add a percentage value to the rate, so that the consumer pays more.

The banks report this mark-up as a way to minimize currency risk. This risk is because the dollar fluctuates and may be trading at a different when the transaction is actually processes. The reality is the difference between the posted rate and the bank rate is pure profit for the banks. The level of active trading and the ranking in the foreign exchange market are both good indicators of a currencies strength in the global market.

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    • Various types of currency, including US dollars, pounds sterling, and euros.
      By: Joop Hoek
      Various types of currency, including US dollars, pounds sterling, and euros.