How exchange rates work, what determines currency values, and why they matter for trade and investment.
Educational content only — not personalized financial, legal, or tax advice.
An exchange rate represents the relative price of one national currency expressed in terms of another. When the euro trades at 1.08 USD, one euro purchases 1.08 US dollars. Foreign exchange trading exceeds $7.5 trillion in daily turnover across global spot, forward, and swap markets.
Floating: The exchange rate is determined by market supply and demand dynamics. Major currencies including the US dollar, euro, Japanese yen, and British pound operate under floating regimes.
Fixed (Pegged): Central banks maintain a target exchange rate against a anchor currency or currency basket. The Hong Kong Dollar maintains a pegged band of 7.75 to 7.85 per US dollar, while Saudi Arabia pegs the riyal at 3.75 per USD.
Managed Float: Central banks allow market forces to determine exchange rates while intervening via foreign exchange reserves to curb volatility. The People's Bank of China sets a daily midpoint rate for the yuan with a 2% daily trading band.
Interest Rate Differentials: Capital flows toward higher short-term risk-adjusted yields, strengthening the currency receiving investment inflows.
Trade Balances: Persistent current account surpluses generate structural demand for domestic currency, whereas trade deficits create selling pressure.
Inflation Differentials: High relative inflation erodes domestic purchasing power, resulting in long-term nominal currency depreciation.
Capital Flows: Foreign direct investment, portfolio inflows, and reserve management create demand for target currencies.
A 10% nominal currency depreciation lowers export prices for foreign buyers while increasing domestic import costs by 10%. For emerging market economies holding foreign debt denominated in US dollars, currency depreciation increases local-currency debt servicing costs relative to government tax receipts.
The Real Effective Exchange Rate (REER) adjusts nominal exchange rates for relative inflation differentials between trading partners. If Country A experiences 5% inflation while Country B records 0% inflation under fixed nominal exchange rates, Country A incurs a 5% real exchange rate appreciation, eroding export price competitiveness in commodity exports.
Covered Interest Parity (CIP) dictates that interest rate differentials between two currencies equal the forward premium or discount in foreign exchange markets. Following the 2008 financial crisis and under post-2010 Basel III balance sheet regulations, non-zero cross-currency basis spreads emerged (e.g., EUR/USD cross-currency basis widening past -50 to -100 basis points during periods of dollar funding strain like March 2020), quantifying foreign exchange swap market frictions and US dollar funding premiums across foreign exchange reserves, balance of payments, floating exchange rates, inflation, international capital flows, and currency devaluation.