How Currency Exchange Rates Work: A Plain-English Guide

What Is an Exchange Rate?

An exchange rate is the price of one currency expressed in terms of another. It tells you how many units of one currency you need to buy one unit of another.

For example, if the USD/EUR rate is 0.92, then 1 US Dollar buys 0.92 Euros. Equivalently, 1 Euro costs about 1.087 US Dollars.

Spot Rate vs Retail Rate

The interbank spot rate (also called the mid-market rate or "real" exchange rate) is the rate banks use when trading with each other. It's the fair market value of one currency in another.

The retail rate is what consumers actually get from banks, currency exchanges, or airport kiosks. It includes a spread — the difference between the buy and sell price — which is the provider's profit margin.

A bank might buy EUR at 0.90 and sell EUR at 0.94, while the spot rate is 0.92. The spread is their profit.

Retail margins vary dramatically:

Major bank foreign exchange: 1–3% above spot rate
Airport currency kiosks: 5–15% above spot rate
Credit card foreign transaction: 1–3% (often the best for travel)
Wise (formerly TransferWise): 0.3–0.5% above spot rate
ATM withdrawals abroad: 1–3% depending on bank and card

The Bid-Ask Spread

When you see currency quotes, you'll often see two prices:

Bid price: What the market will pay to buy the base currency (what you get when selling)
Ask price: What the market sells the base currency for (what you pay when buying)

If EUR/USD is quoted as 1.0850 / 1.0855:

You can sell 1 EUR for $1.0850
You can buy 1 EUR for $1.0855

The spread (0.0005 or 5 pips) is the transaction cost. Narrower spreads = lower cost.

What Moves Exchange Rates?

Exchange rates are determined by supply and demand for currencies, which in turn depends on many factors:

Interest rate differentials — The most important driver. When a country raises interest rates, foreign investors buy its currency to earn higher returns. This increases demand and strengthens the currency.

Example: When the US Federal Reserve raised rates aggressively in 2022–2023, the USD strengthened significantly against most currencies.

Inflation — Higher inflation erodes purchasing power, weakening a currency over time. The Purchasing Power Parity (PPP) theory predicts that exchange rates should adjust to equalize prices between countries.

Trade balance — Countries that export more than they import have higher demand for their currency (buyers need it to pay for exports), which tends to strengthen it. Countries with large trade deficits see their currency weakened.

Economic growth and outlook — Strong economic growth attracts foreign investment, increasing demand for the currency.

Political stability and risk — Political uncertainty, elections, and geopolitical risks cause investors to seek safer currencies. The USD and CHF (Swiss Franc) are traditional "safe haven" currencies.

Market speculation — Short-term exchange rate movements are heavily influenced by traders betting on future rate changes. Forex is the world's largest financial market, with over $6 trillion traded daily.

Fixed vs Floating Exchange Rates

Floating exchange rates (also called "free float"): The rate is determined by market forces. Most major currencies (USD, EUR, GBP, JPY, CHF) use floating rates.

Fixed exchange rates (also called "pegged"): A country fixes its currency to another (usually USD) and intervenes in markets to maintain the peg. Examples: Saudi Riyal (pegged to USD at 3.75 since 1986), Hong Kong Dollar (pegged at 7.8 HKD/USD).

Managed float: Many currencies use a managed or "dirty" float — officially floating but with central bank intervention when the rate moves too far.

Purchasing Power Parity

PPP theory says that in the long run, exchange rates should move toward levels that equalize prices for identical goods. The Economist's "Big Mac Index" is a famous informal measure of PPP — it compares the price of a Big Mac in different countries to assess currency misalignment.

If a Big Mac costs $5.58 in the US and £4.19 in the UK, the implied PPP exchange rate is 4.19/5.58 = 0.75 GBP/USD. If the actual rate is 0.79, the pound appears slightly overvalued vs the dollar.

Getting the Best Exchange Rate

Use a credit or debit card with no foreign transaction fees — Visa and Mastercard use rates very close to the interbank rate; you pay minimal spread
Avoid airport and hotel kiosks — Worst rates, often 8–15% above spot
Use ATMs in the destination country — Draw local currency; check your bank's ATM fee and foreign currency fee
Try Wise for transfers — Close to mid-market rate with transparent fees
Always pay in local currency — When offered dynamic currency conversion (DCC) at a store or ATM, choose local currency; the merchant's rate is always worse

Use our free Currency Converter to check today's exchange rates and calculate conversions instantly.