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Important Key Terms

Below is a short list of some of the important terms pertinent to foreign currency exchange.

Exchange Rate—The value of one currency expressed in terms of another.

Forex—The foreign exchange market (forex) is a globaldecentralizedover-the-counter market for the trading of currencies and is the largest market in the world (followed by the credit market). This market is a necessity because one unit of currency very rarely equals exactly one unit of another currency. The forex is able to facilitate the receipt or payment of units of currency that are equal in value.

Bid Price—The price that a buyer is willing to pay for a unit of currency.

Ask Price—The price that a seller is willing to accept for a unit of currency.

Bid-Ask Spread—The difference between the bid and ask price. Theoreticallybuyers want the smallest possible spreadswhile sellers want the highest spreads. Real-world currency exchanges with brokersbanksor businesses typically do not follow precise market rates. As financial middlemenmost will set exchange rates of their own at bid-ask spreads that return a percentage as profit for doing business. Some call this profit a fee or commission.

Pip—A pip is the smallest unit of value in a bid-ask spread. For example3 pips are the difference between the currency quote of EUR/USD 1.2800/1.2803. A pip is sometimes called a point.

Currency Pair—A quote of the relative value of one currency unit against another currency unit. The first currency in a currency pair is called the base currencywhile the second is called the quote currency.

Interbank (bank-to-bank) Rate—This is the wholesale exchange rate that banks use between themselves.

Major Currencies—This refers to a short list of the most traded currencieswhich generally stay the same year-to-year. Most recentlythis includes the U.S. dollar (USD)Euro (EUR)Japanese yen (JPY)British pound (GBP)Australian dollar (AUD)Canadian dollar (CAD)and the Swiss franc (CHF). The USD in a currency pair with any of the others is known as a major currency pair.

What is Currency?

Currency is a universal medium of exchange for goods and services in an economyand it is believed to have been used as such dating back at least 3,000 years. Before thisit is assumed that barteringwhich is the exchange of goods and services without the use of moneywas likely used. Throughout historycurrency has taken many different forms. Some examples include coinsbarleygoldsilversquirrel pelts8-ton carved limestone rockssaltknivescowrie shellsstampspotato masherspeppercorntea bricksand cheese.

History of Currency

As history has shownanything that a group of people in an economy attaches value to can be used as currency. The first "official" currency was minted in the seventh century BC by King Alyattes of Lydia in modern-day Turkey. For practical reasonsLydian currency took on the form of a round coinwhich became the first ever standardized unit of currency. Paper currencyon the other handwas invented in Asia and was brought back to Europe by Marco Polo after his travels to Asia.

Modern Currency

Modern currency is much more uniform and regulated. Major currencies in the world today take on the physical form of paper bills or coins which are easily carried on a personbut most of a person's currency is typically stored in digital accounts. The value of these currencies is backed by the promise of their issuing governmentswhich makes them fiat money (currency declared by the government to be an official medium of payment but is not backed by a physical commodity). Before fiat money existedcurrencies were usually backed by a commodity such as gold or silver.

While modern currency is physically represented by coins and paper billsmost large-scale currency transactions are done electronically. Modern technology utilizes sophisticated currency exchange mechanisms and systems to exchange currencies between digital accounts rather than physically. Even the exchange of currency for everyday goods and services such as groceries or haircuts involves physical currencies less and less due to the growing popularity of debit cardscredit cardsand mobile payments.

Cryptocurrency

Cryptocurrencies are digital currencies operating independently of a central bank or authorityin which encryption techniques are used to regulate the generation of units of currency as well as to verify the transfer of funds. The current technology behind cryptocurrencies is called blockchainwhich is a decentralized ledger of all transactions across a peer-to-peer network. A prominent feature of blockchain is that participants can confirm transactions without the need for a central clearing authoritysuch as a central bank or government. The value of cryptocurrencies fluctuatesjust like a regular currencyand they can be traded in the same way as any other currency. While bitcoin is currently the most recognizable cryptocurrency with the largest market cap by farthere are many other notable cryptocurrencies such as Ethereum (ETH)Litecoin (LTC)and Ripple (XRP). Some experts say that there is a slight chance that cryptocurrencies become the currency of the future. For the purposes of this calculatorBitcoin is the only cryptocurrency available for conversion at the moment.

Forex and Exchange Rates

Currencies used in different countries are rarelyif everexactly equal in value. As a resultexchange rates (the rate at which a currency is exchanged for another) exist to enable the equal exchange of currencies. Real-time exchange rates are supplied by the foreign exchange market (forex)the same place where most currency transactions take place. The forex is a globaldecentralizedover-the-counter market for the trading of currencies. Each daytrillions of dollars (US) worth of currency are traded. The market functions at high speedswith exchange rates changing every second. The most common forex transactions are exchanges between the U.S. dollar and European eurothe U.S. dollar and the Japanese yenand the U.S. dollar to the British pound Sterling.

Forex Quotes

A forex quote always consists of two currenciesa base currency and a quote currencysometimes called the counter currency. The most common base currencies are EUR (European Union euros)GBP (British pounds)AUD (Australian dollars)and USD (U.S. dollars). The following is an example of a forex quote:

EUR/USD 1.366

In this exampleEUR is the base currency and USD is the quote currencyand what it means is that one euro is worth $1.366 USD. In other words$1.366 is the purchase price in U.S. dollars (aside from external costs such as commission) of one euro. The base currency always equals exactly one. On the other handif the EUR/MXN rate (European Union euro to Mexican peso) is 17.70 instead17.70 Mexican pesos are required to purchase one euro. In the real worldmost exchange rates are given in terms of how much a U.S. dollar is worth in a foreign currency. The euro is different in that it's given in terms of how much a euro is worth in U.S. dollars.

When buying foreign currenciesthere are usually two prices listed: the buying rate and the selling rate. They are sometimes called the "bid price" and "ask price" for the currency pairrespectively. Buying foreign currency from a bank or exchange broker involves the selling (ask) pricewhich is usually higher than the buying price becauselike all merchantscurrency brokers sell high and buy low.

Factors that Influence Exchange Rates Between Currencies

In the real worldthe exchange rates can be influenced by thousands of different factors. The following are a few:

• Differences in inflation—From an international currency exchange standpointthe currency of one economy with low inflation rates will generally see a rise in currency value as purchasing power increases. The currency of another economy with higher inflation will usually depreciate in relation to a lower inflation currency.
• Differences in interest rates—the interest rates may affect the demand of a currency as well as the inflation rate of an economywhich can drive the exchange rates up or down.
• Trade Deficits—If an economy is spending more than it is earning through foreign trade (goodsservicesinterestdividendsetc.)it is operating at a deficit. In other wordsit requires more foreign currency than it receives through the sale of exportssupplying more of its own currency than foreigners demand for its products.
• Politics—Governments can enact policies or regulations that directly or indirectly impact exchange rates. Alsoeconomies with stable politics generally make better foreign investments than economies that constantly suffer from political strife. Perceived instability causes a loss of confidence in currencies within economies and a movement of foreign funds into more stable economies.
• Economic performance—The performance of economies also dictates the exchange rate of their currencies. When global capital searches for the best place to make a returnstrong economies are usually a good choice. As a resultan influx of capital into a certain economy will increase the buying power of that economy's currency.

Some Tips for Traveling Overseas

Anyone who desires to travel to a destination that uses a different currency can benefit from doing some research in advance.

• Whether exchange rates are better abroad or domestically depends a lot on the destinationbut generallyit is better to exchange domestically before traveling to a foreign destination. There are fewer time constraintsand exchanging domestically removes the possibility of encountering difficulties that may arise from trying to exchange money in an unfamiliar region where a person may not speak the language. In the U.S.some banks and credit unions provide exchange services that normally provide better exchange rates and lower fees than other methods. It is also possible to order foreign currency on some currency converting websites that will deliver it via mail. In additioninternational airports normally have kiosks or stores for currency exchange. They are convenientbut they normally have the worst exchange rates and highest fees.
• When buying currency abroadmost people will simply choose the most convenient optiontypically kiosks situated in airportshotelsand high-traffic tourist areas that take advantage of desperate people who can't be bothered to look for better deals. It is advisable to first search for an overseas branch or ATM of your bank. Otherwiselocal banks and fee-friendly ATMs normally have better deals.
• Destinations that are credit card friendly make it easier for foreigners with credit cards or debit cardsas they don't have to fumble over large amounts of foreign cash or pay large commissionssince credit card or debit card exchange rates tend to be pretty close to wholesale market rates. Alsocredit cards and debit cards are probably a safer alternative to holding a bunch of cash. Howeverkeep in mind that a lot of cards not oriented towards travel perks will have foreign transaction fees.
• It is common for people to come back from foreign destinations with some foreign currency left over. There's not much else to do with it aside from keeping it as memorabiliabut it is possible to sell it back to a bank or broker. Againselling back to banks or credit unions is normally preferred in terms of exchange rates and fees.