How do exchange rates work?

Since the official introduction of euro banknotes and coins in January 2002 in the twelve States of the euro zone (Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Portugal, Spain and the Netherlands) and its gradual adoption by other States of the European Union (Cyprus, Estonia, Latvia, Lithuania, Malta, Slovakia and Slovenia), only a few of us remember how worked exchange rates between national currencies before the arrival of the euro. However, it could be useful, especially if you want to travel in a country which doesn’t use the euro.  

Floating or fixed rates?

Currency exchange rates display how much one unit of currency can be exchanged for another currency. There are two types of exchange rates, floating and fixed. Currency floating exchange rates change constantly based on a multitude of factors. Like equities in the stock market, floating rates are determined by the forces of supply and demand in the foreign exchange market (Forex). If demand exceeds supply because companies within the monetary zone are doing well in the markets and investors have confidence in the corresponding currency, the rate of the currency increases. And vice versa: if sellers exceed buyers because, within the monetary zone, companies are doing less well or countries are facing political problems, the rate of the corresponding currency decreases. The floating exchange rate regime is applied to the majority of the currencies in the world. This is the case with the euro and the U.S. dollar.

Some countries prefer to use a fixed exchange rate. In this case, the currency is set and maintained artificially by the government and pegged to a benchmark (generally a currency like the euro or the U.S. dollar or a basket of currencies). In China, the renmimbi (also known as Chinese yuan) is pegged, since 2005, to a basket of 3 currencies: the euro, the U.S. dollar and the Japanese yen.   

The most active and popular financial instrument in the world is the euro/U.S. dollar exchange rate or the value of the euro compared to the U.S. dollar. This indicator is permanently followed by financial and economic circles and world’s media. The two currencies are the most exchanged in the Forex market and you can exchange them almost everywhere in the world. 

Sell or buy rate? 

If you intend to travel outside of the euro zone, you have to exchange your euros at your bank or an exchange office. Be careful, there are two rates: the sell rate, the rate at which foreign currency is sold in exchange for local currency, and the buy rate, the rate at which foreign currency is bought back from travellers to exchange into local currency. For example, if you intend to head to the United States, you will exchange your euros for U.S. dollars at the sell rate. And when you will return from the United States with your U.S. dollars, you will exchange your U.S. dollars back into euros at the buy rate. Of course, in the United States, you will do the opposite. As euro is not the local currency in the United States, you will buy dollars at the buy rate and sell dollars at the sell rate. 

Things are getting more complicated if you want to exchange foreign currency for another foreign currency. For example, you are in Luxembourg and you intend to exchange British pounds for U.S. dollars. As a first step, you have to exchange your British pounds for euros at the buy rate. As a second step, you have to buy U.S. dollars at the sell rate. 

Be careful with the fees and charges!

Be careful with the fees  – they may vary significantly from one financial institution to another – and select the place where you will exchange your money. If it is an international currency, do it in Luxembourg where the rates will be probably more interesting than abroad. If your destination is an exotic country, the best thing to do is to exchange your currency there and take only the necessary amount of money. Be careful too with your credit card: an additional charge will be applied. In case of doubt, contact your usual bank agency for more information. 

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