What are foreign exchange markets and how do they work?
There is no central market where currencies can be traded, such as the London Stock Exchange or the NASDAQ for shares, but, instead, a decentralised market accessed by national central banks - like the Bank of England or the Federal Reserve in the US - or multi-national institutions which engage with buying or selling currencies on behalf of their clients.
The price at which these currency trades take place is known as the interbank rate, and it changes at an exceptionally rapid pace to meet the conditions of the market. Only central banks, multi-national banks and a few select others can access these rates.
Companies like Times Currency Services use this primary network of multi-national banks to buy and sell currencies around the world, effectively creating a secondary foreign exchange market where, instead of big banks trading millions of dollars, smaller businesses and individuals trade smaller quantities of money.
In order for companies like Times Currency Services to offer this service to smaller businesses and individuals, a slightly different exchange rate is offered. The difference between this rate and the interbank rate is known as the spread and dictates how much money companies like Times Currency Services retain from each trade.
Why have exchange rates been changing?
The majority of developed world currencies are free-floating, meaning the value of that country’s currency can rise and fall against others as the markets see fit.
Of the world’s ten most traded currencies, nine are free-floating. Currencies can also be managed, or ‘pegged’, to other assets including precious metals or even another country’s currency.
Broadly speaking, free-floating exchange rates follow the laws of supply and demand. If a shift takes place that affects either the demand for or the supply of a currency, the price of that currency will shift also. These shifts can be the result of economic, political or central bank policy changes, or something wholly separate to the economic and financial system.
How can changing exchange rates affect you?
Whether you are buying or selling property abroad, paying school fees or moving money you earned abroad, currency markets will have an effect on the price you’ll end up paying.
If, for example, you’ve decided to buy a house in France, have agreed on the price but don’t need to pay for another two months’ time, every per cent of change in the EUR/GBP rate will have a direct impact on your bottom line.
At the time of writing, the EUR/GBP exchange rate is around 0.90, making a EUR 300,000 house cost around £270,000. However, should the value of the pound fall by 2.5%, EUR/GBP would rise to over 0.9225, lifting your eventual payment for the house to nearly £277,000 – meaning you’re paying an additional £7,000 for the same house; that’s the price of a new kitchen.
Nonetheless, should exchange rates move in your favour (the pound strengthening in this example) then you’d end up spending less to honour your euro payment.