What is an Exchange Rate and What Does It Mean?

What every traveler needs to know about exchange rates

exchange rate board of currencies
••• TravelAsia/Asia Images/Getty Images

Edited by Joe Cortez, March 2018

If you're planning on traveling abroad any time soon, you'll have likely come across the term "exchange rate". What is it? What do you need to know about it before you plan your trip? And how can it save you money on your vacation?

What is a foreign exchange rate? 

A foreign exchange rate is the relative value between two currencies. Simply put by The Balance: "Exchange rates are the amount of one currency you can exchange for another."

In travel, the exchange rate is defined by how much money, or the amount of a foreign currency, that you can buy with one US dollar. The exchange rate defines how many pesos, euros, or baht you can get for one US dollar (or what the equivalent of one dollar will buy in another country).

How do I calculate the foreign exchange rate? 

Calculating an exchange rate is simple, but can change on a day-to-day basis. As an example: let's say the Euro exchange rate is 0.825835. That means one U.S. Dollar buys, or can be exchanged for, or is "worth" 0.825835 euros. 

In order to find out how much two euros is worth in US dollars, divide 1 (as in one dollar) by 0.825835 to calculate how many US dollars one Euro is worth: $1.21. Therefore:

  • 1 USD = 0.825835 Euros
  • 1 Euro = 1.21090 USD

By using the exchange rate, you can see that $1 equals a little over .80 Euros. Two U.S. Dollars equals about 1.65 Euros, while two Euros equals about $2.40 in U.S. money.

 

Of course, there are easier ways to determine the exchange rate in the country you are visiting. Websites and currency calculator applications, like XE's currency converter and current exchange rate calculator, can help you make smart decisions about your money before and during your trip. 

What is a flexible exchange rate? 

The majority of currency exchange rates you will experience are flexible exchange rates. That is, the rate of exchange can rise or decline based on economic factors.

These situations can change on a daily basis, often by small fractions during your trip. 

Flexible exchange rates between currencies are determined by a foreign exchange market, or "forex" for short. These markets regulate the prices by which investors are purchasing one currency with another, with the hopes of making more money when that nation's money gains strength. 

For an example of a flexible exchange rate, look at the shifts between the United States and Canada. In April 2017, one U.S. Dollar was worth $1.28 Canadian Dollars. Between April and August 2017, the value dropped by nearly eight cents, making the Canadian Dollar slightly stronger in exchange. But by the beginning of 2018, the American Dollar regained strength. If you took a vacation to Niagara Falls, Canada in May 2017, your American Dollars would have been worth $1.37 Canadian Dollars, giving you more buying power. But if you took that same trip in September 2017, your American Dollars would have only been worth $1.21 Canadian Dollars each - a major loss in currency strength. 

What is a fixed exchange rate? 

While most nations price the difference in their currencies on the foreign exchange market, some nations control the exchange rate of their currency against outside monetary units.

This is called a fixed exchange rate. 

Different governments maintain different rationales for maintaining a fixed exchange rate. In Cuba, where one Cuban Convertible Peso is equal to one American Dollar, the U.S. embargo and political differences caused the Cuban government to treat tourist dollars the same as American dollars. Meanwhile in China, the government elects to "peg" their currency against the Dollar, leading some to consider the world's most populous nation a "currency manipulator."

Think of it like this: fixed exchange rates seek to maintain a "stable" exchange rate by controlling how much a foreign currency is worth, while flexible exchange rates are based on several economic factors, including the strength of a nation's overall financial health. 

What can impact an exchange rate? 

Flexible exchange rates can change day to day, but are often in very small increments of less than one cent.

But major economic factors, like government shifts or business decisions can have impacts on international exchange rates. 

For instance, consider the shifts in the U.S. Dollar between 2002 and 2015. When the national debt of the United States raised significantly between 2002 and 2007, the American Dollar dropped in value compared to their international counterparts. When the economy entered the "Great Recession," the dollar gained some strength back, because major corporations were holding onto their wealth. 

When Greece was on the verge of an economic meltdown, the Euro weakened in value. In turn, the American Dollar grew in strength, giving Americans more buying power in the European Economic Area. The British referendum vote to leave the European Union shifted the dollar's value even further, pulling it closer to being even with the British Pound Sterling. 

International situations can have a major effect on how much the U.S. Dollar is worth abroad. By understanding how these things could change your buying power abroad, you can quickly make decisions on when to exchange your cash for local currency, or hold on to American Dollars and spend using your credit or debit card. 

Are bank fees considered part of exchange rates? 

Before you travel, you may receive offers for credit cards or debit cards with "no international transaction fees." Do these have any bearing on foreign exchange rates? 

As a service to travelers, banks can elect to process purchases made on debit or credit cards while they are abroad. However, many also choose to tack on an additional fee – sometimes called an "international transaction fee" – to the transaction. This is usually charged as a percentage of the transaction fee and may be separate of the bank fees. 

Because these are separate charges, an international transaction fee is not considered part of an exchange rate. To get the best rates while abroad, be sure to always use credit and debit cards that do not charge an international transaction fee

Why do I need to know what the exchange rate is? 

Before you travel, or while you're traveling, you need to know what the exchange rate is so you'll know how much your money is worth in another country. If a dollar isn't worth a dollar abroad, you can budget accordingly, and now how much you're actually spending while traveling.

Additionally, knowing the exchange rate before you travel can help you get the best deal on currency conversion before you go. It is always important to carry a little foreign currency upon your arrival, so by tracking exchange rates before you travel, you can get the most money from your bank or chosen exchange before you travel.

How can I get the best exchange rate for my money?

Don't rely on street kiosks or airport kiosks in another country to give you an accurate or completely fair exchange rate. Currency exchange places on the street or in the airport know that they don't have to do anything to attract travelers, so they slap a huge commission on top of every transaction. As a result, you will exchange a large amount of your money with one of these exchanges, just to get very little in return.

If you know what the rate is, the best places to exchange your money is at a bank or an ATM. Because banks run on standard hours around the world as well, it may not always be convenient to take your cash to a bank. ATMs offer a good backup plan because you can usually get local currency at the current exchange rate. Smart travelers also use a debit card that charges no ATM fees or international transaction fees, so you always get the true value of your cash. 

But if you elect to use a credit card abroad, your best bet is to always elect to pay in the local currency. In some situations, payment processing companies may elect to add transaction fees if you decide to pay in American Dollars, which only reduces your buying power. If your credit card has no international transaction fees, paying in the local currency can give you the best exchange rate at the point of purchase without additional hidden fees tacked on.