Exchange Rates Explained: How Currencies Are Valued & What Moves Them
How Exchange Rates Work
Currencies trade in the foreign exchange (forex) market — the largest financial market in the world with over $7 trillion in daily volume. Exchange rates are set by supply and demand: when more people want to buy dollars, the dollar strengthens; when demand falls, it weakens.
For investors, exchange rates matter because they determine the value of foreign investments when converted back to your home currency. A U.S. investor holding European stocks benefits when the euro strengthens against the dollar (and loses when it weakens), even if the underlying stock price is flat.
Fixed vs Floating Exchange Rates
| Feature | Fixed (Pegged) | Floating (Market-Determined) |
|---|---|---|
| How Rate Is Set | Government/central bank fixes rate to another currency or basket | Supply and demand in forex markets |
| Central Bank Role | Must intervene to maintain the peg (buy/sell reserves) | May intervene occasionally but doesn’t target a level |
| Stability | Predictable for trade and investment | Can be volatile short-term |
| Flexibility | Limited — can’t adjust to economic shocks easily | Adjusts automatically to economic conditions |
| Risk | Speculative attacks if peg becomes unsustainable | Currency crises less likely but volatility higher |
| Examples | Hong Kong dollar (pegged to USD), Saudi riyal | USD, EUR, JPY, GBP |
What Drives Exchange Rate Movements
| Driver | Effect on Currency |
|---|---|
| Interest Rate Differentials | Higher rates attract foreign capital → currency strengthens |
| Inflation Differentials | Lower inflation → currency strengthens (preserves purchasing power) |
| Trade Balances | Surpluses create demand for domestic currency → strengthens |
| Capital Flows | Foreign investment inflows → demand for currency → strengthens |
| Economic Growth | Stronger growth attracts investment → currency tends to strengthen |
| Political Stability | Uncertainty drives capital outflows → currency weakens |
| Central Bank Policy | Hawkish policy → stronger currency; dovish → weaker |
| Market Sentiment | Risk-on flows weaken safe havens (USD, JPY, CHF); risk-off strengthens them |
Real vs Nominal Exchange Rates
The nominal exchange rate is the raw rate you see quoted — EUR/USD at 1.08. The real exchange rate adjusts for price level differences between countries. If U.S. prices rise faster than European prices, the real dollar strengthens even if the nominal rate doesn’t change, making U.S. goods less competitive abroad.
The real effective exchange rate (REER) measures a currency against a trade-weighted basket of partners, adjusted for inflation. It’s the best measure of a currency’s true competitiveness. Central banks and trade economists watch the REER closely. See also: purchasing power parity.
How Exchange Rates Affect Investments
Currency exposure is an often-overlooked source of return and risk. When the dollar strengthens, U.S. investors in foreign assets lose on conversion. When the dollar weakens, they gain. For multinational companies, a strong dollar reduces the value of overseas revenues when reported in dollars — a headwind for earnings of companies in the S&P 500 with significant international sales.
Bond investors face similar dynamics. Foreign bond returns combine the local yield plus any currency gain or loss. This is why many institutional investors hedge currency risk on international fixed income — the volatility from currency can exceed the yield.
Key Takeaways
- Exchange rates are set by supply and demand in the $7+ trillion daily forex market.
- Interest rate differentials, inflation, trade balances, and capital flows are the primary drivers.
- Fixed exchange rates offer stability but are vulnerable to speculative attacks; floating rates adjust automatically.
- Currency movements directly impact international investment returns, corporate earnings, and import prices.
- The real exchange rate (adjusted for inflation) is a better measure of competitiveness than the nominal rate.
Frequently Asked Questions
What causes exchange rates to fluctuate?
Exchange rates move based on interest rate differentials, inflation expectations, trade flows, capital flows, political events, and market sentiment. Central bank policy decisions — especially unexpected ones — are among the biggest short-term movers of currency markets.
How does a strong dollar affect U.S. investors?
A strong dollar reduces the value of foreign investments when converted back to USD, hurting international equity returns. It also pressures earnings of U.S. multinationals with significant overseas revenue. Conversely, it makes imports cheaper and helps keep domestic inflation lower.
What is the difference between fixed and floating exchange rates?
Fixed rates are maintained by government intervention — the central bank buys or sells reserves to keep the rate at a target. Floating rates are determined by market forces. Most major currencies (USD, EUR, JPY) float freely, while some emerging markets and smaller economies maintain pegs.
How do interest rates affect exchange rates?
Higher interest rates attract foreign capital seeking better returns, increasing demand for the currency and pushing it higher. This is why Fed rate decisions move the dollar — and why currency traders obsess over rate differentials between countries.
What is the DXY Dollar Index?
The DXY measures the U.S. dollar against a basket of six major currencies: euro (57.6%), Japanese yen (13.6%), British pound (11.9%), Canadian dollar (9.1%), Swedish krona (4.2%), and Swiss franc (3.6%). It’s the most widely followed gauge of dollar strength but is euro-heavy.