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Forex for beginners: How currency exchange rates actually work

by , 13 October 2014

When you go overseas on holiday, you want to know the exchange rate of the rand against whatever currency it is you're buying. The weaker the rand, the more expensive the other currency is.

But did you know that exchange rates can have a big impact on the prices you pay in the shops, a company's accounts and the value of your investments?

So how exactly determines exchange rates of currencies?

Let's take a closer look at the ins and outs of exchange rates…

What impacts an exchange rate?

There are many factors that can affect the value of one currency against another.

Factors include:

  • The strength of the two countries’ economies;
  • Interest rates;
  • Economic policies; and
  • Internal politics.

In the end, it all boils down to supply and demand, Phil Oakley in Money Week explains. The more in demand a currency is, the stronger the currency will become.

On the other hand, the more people sell one currency, the more its value falls.

How currencies can move

Let’s have a look at an example…

A British company decides to build a factory in the US. It will need to pay for the new factory in dollars. This means it has to exchange pounds for dollars.

Because of the demand for dollars, it may strengthen. This may cause the value of the pound to fall, depending on what’s going on elsewhere.

Once the factory’s completed, it starts to make a profit in dollars. The company pays its dividends in pounds, so it has to sell dollars to buy pounds.

The exchange rate risk here comes if there are big changes in the value of the dollar/pound exchange rate. If it moves significantly, it can have a large impact on the British company’s profits.

So there you have it, how currency exchange rates actually work.

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Forex for beginners: How currency exchange rates actually work
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