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Exchange Rate: Determination and Conversion Across Countries

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  • 0:01 Intro
  • 0:34 Definition and Purpose
  • 0:57 Types
  • 2:05 How They Work
  • 3:20 Conversion Calculations
  • 5:31 Lesson Summary
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Lesson Transcript
Instructor: Aaron Hill

Aaron has worked in the financial industry for 14 years and has Accounting & Economics degree and masters in Business Administration. He is an accredited wealth manager.

Understand what exchange rates are and the different types that can be used by governments and countries. See how they operate and how the conversion process works across countries.

Importance of Understanding Exchange Rates

If you ever have to travel outside the United States for work, take a cruise vacation, or possibly even purchase goods online from companies based outside your country, you will want to understand exchange rates and how your money is converted into other currencies. Having a basic understanding will help make sure you get the best deal on foreign goods and ensure you know exactly how much you are paying for something when you make that purchase from an online site quoting goods in something other than dollars.

Definition and Purpose

An exchange rate is the rate at which one country's currency can be traded for another country's currency. They exist so countries and firms can do business with each other and pay in the appropriate currency. They also are helpful and necessary when individuals travel to other countries and have to exchange their dollars for the local foreign currency.

Types

Countries can use exchange rates in a variety of different ways. They can have fixed exchange rates, flexible exchange rates, or partially flexible exchange rates. Let's briefly define each.

  • Fixed exchange rate is an exchange rate that is set by officials, and the government commits to buying and selling currencies at that fixed rate. The purpose is to keep the currency trading in a very narrow band, and it can also be referred to as a pegged rate.

  • Flexible exchange rate is an exchange rate that is set by market forces of supply and demand between different countries for each other's currencies. The demand for a country's goods, the political stability, interest rates, inflation, and many other economic factors all influence the rate. These rates between countries can vary daily.

  • Partially flexible exchange rate is primarily set by supply and demand forces but is sometimes influenced by the government strategically buying and selling currencies to influence the prices of their currency.

How They Work

Now that we know what exchange rates are, the different types, and why they exist, let's explore how they work and are used across countries.

When an American company purchases goods from a Japanese company, for example, the Japanese company will often want to be paid in their own currency, which is Japanese yen. Why, you might ask? The Japanese company most likely needs their own currency so they can pay their workers and run operations inside Japan where they are located. To complete the transaction, the American company will enter into the foreign exchange market, which is a financial currency market made up of many buyers and sellers that is open nearly 24 hours a day during the week.

How much will the American company pay to convert their dollars to Japanese yen? The answer depends on when the American company is ready to pay. If they are ready to pay today, they will use the spot exchange rate, which is the current exchange rate. If it is a transaction in the future, it may use the forward exchange rate, which refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.

Conversion Calculations

Exchange rates exist for hundreds of currencies across the globe. There is a different American dollar exchange rate for the currencies of England, Japan, China, Mexico, Brazil, France, and many other countries.

For example, one U.S. dollar may equal 0.6 British pounds. When compared to Mexico, though, the exchange rate for one U.S. dollar may equal 13 Mexican pesos! How about the Japanese yen? One U.S. dollar may equal up to 102 Japanese yen. It is almost like one yen is equal to one American cent!

Why is it important to know this? Understanding the exchange rates and conversion ratios will help you decide whether a good or service may be a good deal in another country. Large international firms must constantly monitor these exchange rates with their key trading partners, as this can mean large amounts of money saved or lost to their bottom line.

Let's break this down to a personal example to clarify. If you are an American looking to save money and can buy the same exact pair of jeans in England for 20 pounds, in Mexico for 390 pesos, or in Japan for 3,876 yen, which one is relatively cheaper? Using the hypothetical exchange rates in the above paragraph, let's do the math!

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