How Currency Exchange Rates Work

Updated July 2026 · Sources: BIS, IMF, Federal Reserve, ECB

What Is an Exchange Rate?

An exchange rate is the price of one currency expressed in terms of another. It answers the question: "How many units of Currency B can I buy with one unit of Currency A?"

Exchange rates are quoted in pairs. For example, EUR/USD = 1.09 means 1 euro buys 1.09 US dollars. The first currency (EUR) is the base currency; the second (USD) is the quote currency. The rate tells you how much of the quote currency you need to buy one unit of the base currency.

Floating vs. Fixed Exchange Rates

Countries adopt one of two main exchange rate regimes:

Floating (Flexible) Exchange Rates

The currency's value is determined by supply and demand in the foreign exchange market. Central banks may intervene occasionally, but the rate moves freely based on market forces.

Major floating currencies: USD, EUR, GBP, JPY, CAD, AUD, CHF, NZD, SEK, NOK, MXN, BRL, ZAR, KRW, SGD.

Advantages: Automatic adjustment to economic shocks, independent monetary policy, no need for large foreign exchange reserves.

Disadvantages: Volatility, uncertainty for trade and investment, potential for speculative attacks.

Fixed (Pegged) Exchange Rates

The currency's value is tied to another currency (usually USD or EUR) or a basket of currencies. The central bank commits to buying or selling its currency to maintain the peg.

Major pegged currencies: HKD (pegged to USD at ~7.8), SAR (pegged to USD at 3.75), AED (pegged to USD at 3.67), CNY (managed float with reference to basket), many Gulf currencies pegged to USD.

Advantages: Stability, predictability for trade, anchors inflation expectations.

Disadvantages: Loss of independent monetary policy, requires large reserves, vulnerable to speculative attacks (e.g., 1997 Asian Financial Crisis, 1992 UK Black Wednesday).

Regime	Examples	Central Bank Role	Volatility	Monetary Independence
Free Float	USD, EUR, JPY, GBP	Minimal intervention	High	Full
Managed Float	CNY, INR, RUB	Periodic intervention	Moderate	Partial
Currency Board	HKD, BGN	Automatic, rules-based	Low	None
Hard Peg	SAR, AED, BHD	Fixed to USD	Very Low	None
Dollarization	Panama, Ecuador, El Salvador	Uses USD directly	None	None

What Drives Exchange Rate Movements?

Exchange rates are determined by the interaction of supply and demand. The key drivers are:

1. Interest Rate Differentials

Higher interest rates attract foreign capital, increasing demand for the currency and strengthening it. This is the carry trade—borrow in a low-rate currency (e.g., JPY at 0.5%) and invest in a high-rate currency (e.g., USD at 5.5%). The rate differential is the primary driver of most major currency movements.

Example: In 2022-2023, the US Federal Reserve raised rates aggressively (to 5.25-5.50%) while the Bank of Japan kept rates near zero. The USD/JPY rate rose from 115 to over 150—a 30% yen depreciation—driven almost entirely by this interest rate gap.

2. Inflation Differentials

According to Purchasing Power Parity (PPP), currencies of countries with higher inflation should depreciate relative to those with lower inflation. Over long periods (10+ years), PPP holds reasonably well. Over short periods, interest rates and capital flows dominate.

3. Economic Growth & Employment

Stronger economic growth attracts foreign investment, increasing demand for the currency. However, the relationship is complex: strong growth can also lead to higher inflation, which weakens the currency. The net effect depends on whether growth is driven by productivity gains (currency-positive) or demand stimulus (currency-neutral or negative).

4. Current Account Balance

A country running a trade surplus (exports > imports) sees net foreign demand for its currency, which strengthens it. A trade deficit (imports > exports) means the country must sell its currency to buy foreign goods, weakening it. The US is a notable exception: despite persistent trade deficits, the USD remains strong due to its role as the global reserve currency and the depth of US capital markets.

5. Political Stability & Geopolitics

Political uncertainty weakens currencies as investors seek safety. Wars, elections, policy shifts, and trade disputes all impact exchange rates. The Russian ruble collapsed 40% in February 2022 following the invasion of Ukraine. Brexit caused GBP to fall 15% against USD in 2016.

6. Central Bank Policy & Intervention

Central banks influence rates through monetary policy (interest rates, quantitative easing/tightening) and direct foreign exchange intervention (buying/selling currency in the market). The Bank of Japan spent over $60 billion in 2022 to defend the yen. The Swiss National Bank maintains the world's largest FX reserves relative to GDP to manage the franc.

7. Market Sentiment & Speculation

Short-term rate movements are often driven by sentiment, technical analysis, and algorithmic trading. The forex market is dominated by institutional traders (banks, hedge funds, corporations), with retail traders accounting for less than 5% of volume. Algorithmic trading now executes 70-80% of forex transactions.

Bid, Ask, and the Spread

When you see an exchange rate, it is actually two rates:

• Bid: The price at which the market maker will buy the base currency (what you get when selling)
• Ask (Offer): The price at which the market maker will sell the base currency (what you pay when buying)
• Spread: The difference between bid and ask. This is the market maker's profit.

Cross Rates

A cross rate is an exchange rate between two currencies that does not involve the US dollar. Cross rates are calculated using the two currencies' rates against a common third currency (usually USD).

The Forex Market Structure

The foreign exchange market is decentralized—there is no single exchange like the NYSE. Instead, it operates as a global network of banks, brokers, corporations, and traders connected electronically.

Market Segment	Participants	Daily Volume	Typical Spread
Interbank	Major banks	~$3.5 trillion	0.1-0.5 pips
Institutional	Hedge funds, corporations, asset managers	~$2.5 trillion	0.5-2 pips
Retail Forex	Individual traders, small businesses	~$300 billion	1-5 pips
Retail Banking	Consumers, travelers	~$50 billion	50-500+ pips (2-10%)

Source: Bank for International Settlements (BIS) Triennial Central Bank Survey 2022. "Pips" are the smallest price move in a currency pair (0.0001 for most pairs, 0.01 for JPY pairs).

Key Takeaways

1. Exchange rates are prices. They are determined by supply and demand in the largest, most liquid financial market in the world.
2. Interest rate differentials are the dominant driver. Currencies with higher interest rates tend to appreciate, all else equal.
3. Most major currencies float. USD, EUR, GBP, JPY, CAD, AUD, and CHF move freely. Pegged currencies (HKD, SAR, AED) require central bank intervention to maintain their fixed rates.
4. The spread matters. The rate you see on Google or our converter is the mid-market rate. The rate you actually get includes a spread of 0.5% (Wise) to 10% (airport kiosk).
5. Cross rates are derived. Any two currencies can be converted through a common third currency. Our converter uses EUR as the base for all calculations.
6. Volatility is normal. Major pairs move 0.5-1.0% per day. Exotic pairs can move 2-5% in a single session. Plan accordingly for large conversions or travel.