What Is an Exchange Rate?
An exchange rate is the price of one currency expressed in another currency. It’s the rate at which two currencies exchange for each other.
EUR/USD 1.0850 means the exchange rate of the euro to the dollar is 1.0850. One euro costs 1.0850 dollars. That’s the exchange rate.
Exchange rates fluctuate constantly. They move based on supply and demand for currencies, just like stock prices move based on supply and demand for stocks.
Why Exchange Rates Exist
Imagine you’re a German company selling machinery to a US buyer. The buyer wants to pay in dollars, but you need euros to pay your German workers.
You have three options:
- Accept dollars, exchange them to euros at a bank (paying a fee)
- Ask the buyer to pay in euros (inconvenient for them)
- Let the buyer pay in dollars, and accept the exchange rate risk
This is where the forex market comes in. Exchange rates allow you to convert one currency to another. The exchange rate is the negotiated price.
How Exchange Rates Are Determined
In modern forex, exchange rates are determined by supply and demand in the 24/5 forex market.
When more people want to buy EUR (for investments, paying bills, etc.), demand increases. With higher demand and limited supply, EUR becomes more expensive in USD. EUR/USD rises.
When more people want to sell EUR, supply increases. With higher supply and limited demand, EUR becomes cheaper in USD. EUR/USD falls.
What moves supply/demand?
- Interest rates: Higher EUR rates attract capital to euros, increasing demand. EUR strengthens.
- Economic growth: If EU economy is growing, investors want EUR assets, increasing demand.
- Geopolitical risk: Wars or political instability reduce demand for affected currency. That currency weakens.
- Inflation: Unexpected high inflation weakens currency (reduces demand for assets).
- Central bank policy: Rates, QE, tightening all affect demand.
- Sentiment/Risk: In crises, investors flee to safe-haven currencies like USD or JPY.
Nominal vs. Real Exchange Rates
Nominal Exchange Rate
The actual quoted price. EUR/USD 1.0850. This is what you see on your broker.
Real Exchange Rate
Adjusted for inflation differences. If EUR zone inflation is 3% and US inflation is 2%, the real value of EUR is different from nominal.
For traders, nominal rates matter. For macroeconomic analysis and long-term comparisons, real rates matter.
Exchange Rates and Purchasing Power
There’s a theory (purchasing power parity) that exchange rates should equalize prices across countries.
Example: If a Big Mac costs 5 euros in Germany and 5 dollars in the US, the exchange rate should be 1.0 (equal value). If EUR/USD is 1.20, then the Big Mac is more expensive in US in real terms.
This theory suggests exchange rates revert to fair value over time. But it’s a long-term tendency. In the short-term (months, years), exchange rates can be far from purchasing power parity.
This is why forex trading is profitable—rates are constantly out of fair value, creating opportunity.
Exchange Rates and Forex Trading
As a trader, you profit from exchange rate movements.
Long Trade Example:
You believe EUR/USD will rise (euro will strengthen). You buy at 1.0850. If it rises to 1.0950, you’ve gained 100 pips. On 1 lot (100,000 euros), that’s 1,000 USD profit (before spreads and commissions).
Short Trade Example:
You believe GBP/USD will fall. You sell at 1.2600. If it falls to 1.2500, you’ve gained 100 pips. On 1 lot, that’s 1,000 USD profit.
Leverage magnifies this. With 50:1 leverage, you control 100,000 euros with 2,000 USD. A 100-pip move becomes a 50% account return (before commissions).
Fixed vs. Floating Exchange Rates
Floating Rates (Modern forex)
Most currencies have floating rates—determined by market supply/demand. EUR, GBP, USD, JPY all float freely.
Fixed Rates (Pegged currencies)
Some currencies are pegged to another currency or gold. Hong Kong Dollar (HKD) is pegged to USD at 7.8 HKD = 1 USD. This peg is maintained by the central bank buying/selling to keep it stable.
Pegged currencies are less volatile but can suddenly re-peg (devalue) if conditions change. Trading pegged pairs is different—lower volatility but event risk.
Exchange Rates and Your Trading Account
Your profits/losses are in your account currency (usually USD or EUR).
If you trade USD/JPY and make 100 pips, your profit is 100,000 yen. But your account needs to convert that to your account currency. The exchange rate at which conversion happens affects your actual USD profit.
Smart traders pay attention to this. Sometimes, even if you win a trade, forex conversion can reduce your profit if the account currency weakens.
Bid-Ask in Exchange Rates
The exchange rate you see is actually two prices:
Bid: The price at which you can sell the base currency. If EUR/USD bid is 1.0850, you can sell euros at 1.0850.
Ask: The price at which you can buy the base currency. If EUR/USD ask is 1.0852, you can buy euros at 1.0852.
The difference (2 pips) is the spread—the broker’s profit or your trading cost.
Real-World Exchange Rates
When traveling, the exchange rate at your bank is different from the forex market rate. Banks add a markup (5-10% typically). International wire transfers have similar markups.
This is why forex traders can profit from currency inefficiencies. They trade the actual market rate, not a retail bank’s marked-up rate.
PipJournal Converts Your Profits
PipJournal automatically converts all your trades to your account currency, handles multi-pair positions with different base currencies, and tracks your actual P&L accounting for currency conversion rates. If you trade 10 different pairs, PipJournal’s math is cleaner and more accurate than spreadsheets.
