How to Calculate Exchange Rates
Updated August 1, 2022
When one currency is converted into another, this is done by an exchange rate – how much of one currency the other is worth. This is what determines how the value of two currencies relate to each other; for example, how much the US dollar is worth compared to the euro.
As a basic example, if you lived in Australia and were planning a trip to the US, you would refer to the exchange rate to see how much Australian currency you would need to spend to purchase a single US dollar.
In more complex terms, exchange rates also inform trades on the global forex (foreign exchange) market and are used by businesses worldwide in the execution of high-value transactions.
How an exchange rate is determined is dependent on the exchange rate regime adopted by a given country:
Free-floating – The most common model used, a free-floating regime is influenced by the forex market. A currency's value fluctuates based on factors like supply and demand, a country's economic stability and global events. If we take the British pound, for example, it may be strong against other currencies in times of prosperity, but if the UK experiences a financial crash, its currency falls in value.
Fixed – Also known as a pegged rate, a fixed exchange rate is one in which a country’s government looks to establish a level of stability by fixing the value of its currency against that of another country, or against an asset (historically, gold). Fixed rates are no longer common practice but are still adopted by some countries, including the United Arab Emirates and Hong Kong – both countries fix their currencies against the US dollar, meaning they can always be exchanged for around the same amount of USD.
Hybrid rates – Fixed exchange rates are precarious, particularly when pegged to the currency of another country. If said country’s currency experiences extreme volatility, so too would the fixed currency. For that reason, some countries have adopted exchange regimes that combine fixed and floating models. Here a currency is still fixed but allowed a level of fluctuation based on external influencing factors.
Restricted currency – Some countries do not permit the exchange of their currency outside their borders. This model is adopted by weak or emerging economies that want to protect the value of their currency from outside speculation. Currently, countries including Nepal, Ethiopia, Morocco and Zimbabwe adopt restricted currency regimes. If you wished to obtain the currency of these countries, you would have to do so within the country itself.
On the surface, exchange rates are fairly straight forward. They tell us how much of one currency we can purchase with another.
This is known as the nominal exchange rate. However, what this does not give is a like-for-like comparison of what an amount of money is truly worth once converted: essentially, a currency’s purchasing power.
For example, say you have converted Australian dollars into US dollars at the nominal exchange rate.
To understand the true value of the USD exchanged for, the cost of goods and services in the US compared to the cost of those same goods and services in Australia must be considered.
This is where the following terms come into play:
Each country or group of countries using a single currency, such as the Eurozone, has a consumption basket.
This accounts for the goods and services most consumed, and the price paid for them to give a consumption basket price stated in the domestic currency.
In simple terms, you might think of it as the average cost of living in any given country.
The real exchange rate tells us what your money is actually worth in another country and is calculated by using the nominal exchange rate and the price of each country's consumption basket.
As an example, if you wanted to know what the Australian dollar was truly worth in the US, you would multiply the nominal exchange rate by the price of the US consumption basket, and then divide this by the price of the Australian consumption basket.
If the result of this equation were 1, you would know your money is of equal value in both countries. If the result were above 1, you would know your money is worth less in the other country because you would pay more for goods and services in the US than in Australia, and the opposite if it were below 1.
Again, in simple terms, look at it as the average cost of living.
Real exchange rates are predominantly used for international trade purposes, in other words, import and export. They can, however, be useful in day-to-day life, as they give you an idea of how far your money will stretch once it has been converted to another currency.
As discussed, how much currency you can buy with another is known as the nominal exchange rate.
As you have likely experienced, if you search online you will find a current market exchange rate and a variety of different rates offered to you by those dealing in currency exchange.
This is because whoever you exchange your currency with will look to make a profit on the transaction.
Banks, travel agents, credit card providers and the Bureau de Change will all offer different rates at the same time, as they will all apply a markup.
The same applies if you are trading on the forex market. Exchange rates offered there vary from broker to broker as each applies its own associated fees.
Typically, exchange rates for retail traders are less competitive than those offered to professionals dealing in large values.
The best way to ensure you get the fairest price is to do your research. If you have ever exchanged currency at the airport, you will know that you get a far less competitive rate there than you would on the high street, essentially because an airport exchange bureau has a captive market thus adds a greater markup.
When it comes to knowing how to calculate exchange rates yourself, it is important to first understand how they are represented.
Each currency is identified by a three-letter abbreviation and currency classified as either a major, minor or exotic.
The top six most commonly traded currencies are, in order:
- US dollar (USD)
- Euro (EUR)
- Great British pound (GBP)
- Japanese yen (JPY)
- Australian dollar (AUD)
- Swiss franc (CHF)
Major currency pairs are those most commonly traded across the globe and must include USD.
Minor currency pairs are between common currencies not including USD.
Exotic currency pairs are between a more common currency (for example, AUD) and a currency of a developing country (for example, ZAR, the South African rand).
Exchange rates are quoted in the form of currency pairs, for example, USD/EUR.
The first currency, which in this case is the USD, is known as the base currency. This is the currency you are looking to buy. The base currency is always one whole unit. It is sometimes referred to as the transaction currency.
The second currency, here EUR, is known as the quote, terms or counter-currency. This is the currency you are effectively selling to buy the other; this is the value that will fluctuate.
For example, if you were to see the quoted currency pair USD/EUR = 0.83, this means you will pay €0.83 for every single US dollar you purchase.
Here are some examples of how to work out exchange rates.
Take the currency pair quoted above – USD/EUR = 0.83.
If you were converting your euros into US dollars, you would be exchanging the quote currency for the base currency.
Here, you would need to divide the amount you wished to exchange by the quoted exchange rate.
For example, if you are exchanging €3,000, divide that by 0.83 to calculate how many US dollars you get in return:
3,000 ÷ 0.83 = $3,614.46
To reverse the transaction (that is, to exchange US dollars for euros) or exchange the base currency for the quote currency, you would reverse the calculation and multiply your amount by the exchange rate.
So, if you wanted to convert $3,000 into euros:
To compare quotations, you may also want to calculate the percentage markup applied by each currency exchange service.
To do this, take the exchange rate offered and subtract the market exchange rate to establish the difference. Then multiply this by 100 to gain the value as a percentage.
For example, if the USD/EUR market rate is 0.83, but you are offered a retail rate of 0.89:
You can now see that the currency exchange service is charging a 6% markup on the market exchange rate.
If you are confident in working out exchange rates, then a simple conversion is easily made. However, the process becomes a little more complex in certain circumstances, for example, if using an online transfer service to send money overseas.
Here, you would need to account for transfer fees, much in the same way you need to consider markup prices on retail exchange rates.
If you are someone who travels a lot for work and needs to claim back expenses, you will need to work with the exchange rate at the time of your trip, and factor in fees for your payment method, like credit or debit card.
Thankfully, there is a range of online tools that simplify these processes for you:
XE.com – This user-friendly site provides current data on market exchange rates as well as historical data and currency charts. There is also a handy travel expenses calculator that combines historical rates with foreign exchange fees, so you can work out the cost of expenses incurred abroad with ease. It also offers a money transfer service with competitive fees.
Exiap – Exiap works like a comparison site for currency exchange and overseas transfer services so you can find the best deals relative to current exchange rates. You will also find historical data, a currency conversion tool and live exchange rates.
X-Rates – A comprehensive site useful for anyone that needs to monitor several exchange rates at any given time, with X-Rates you can enter a single currency and get up to date information on its strength against multiple other currencies.
TransferWise – Another widely used money transfer service, TransferWise offers competitive and transparent fees for sending money abroad. You can also use it as a comparison site to compare its costs against other providers.
All these sites will show you the current market exchange rates, allowing you to make a better-informed decision when looking at those offered by currency exchange services.
As discussed, most countries adopt flexible exchange regimes, meaning exchange rates can fluctuate, sometimes even daily.
If you are planning on converting money, check the market rate ahead of time and keep your eye on its movement. This will help you spot when your domestic currency is at its strongest so you can get more in return.
Shopping around is the best way to save money, so be sure to work out exactly what you are being charged before you make an exchange.
Do not take it for granted that whichever service you have used historically will always offer the best prices.
Some currency exchange services will advertise their rates with a 0% commission to capture your attention.
Be wary of these. Often you will find that the exchange rate is far less competitive because the commission is hidden within the quote.
Knowing the current market exchange rate will help you avoid this costly mistake.
If you are sending money abroad, it is important to assess both the exchange rate offered and the fees for transferring the funds.
Again, these will vary from provider to provider so shop around and for the best price for the amount you wish to send.
Comparison sites like those listed above are a good place to start, but you should also do your research, as these sites will not always show you all the services available.
If you intend on using a card whilst abroad, research its associated fees before you go.
Many credit cards charge a lot for foreign exchange, especially when used to withdraw cash from an ATM. That said, a lot of providers now offer incentives for travel so using a card can actually save you money. Find out exactly what your provider offers in advance of your trip.
If you are using a credit or debit card to purchase something, make sure you pay in the local currency, as paying in your domestic currency will incur an additional conversion fee.
If you are exchanging money for a holiday, it can often be cheaper to buy with friends or family so you can split the fees between you.
Whatever your reason for converting one currency into another, understanding exchange rates is the only way to ensure you get the fairest price.
Knowing the current market rate and the fees you will pay on top of this allows you to shop around for the best exchange provider, whether converting money for a holiday, sending money abroad or using a payment method like a debit card throughout your travels.