Let’s start with a definition of foreign currency exchange rates. Simply put, foreign currency exchange rates are what it costs to exchange one country’s currency for another country’s currency. For example, if you go to England on vacation, you will have to pay for your hotel, meals, admissions fees, souvenirs and other expenses in British pounds. Since your money is all in US dollars, you will have to sell some of your dollars to buy British pounds. Let’s assume that you have decided to take a trip to England. Before you leave, you go to your bank and buy $1,000 worth of British pounds. If you get 565.83 British pounds (£565.83) for your $1,000, each dollar is worth .56583 British pounds. This is the exchange rate for converting dollars to pounds.
After spending a few days in England, you realize that £565.83 won’t be enough to cover all of your expenses. So you go to a bank in England and buy another $1,000 worth of British pounds. This time, however, you get only £557.02 for your $1,000. The exchange rate for converting dollars to pounds has dropped from .56583 to .55702. This means that US dollars are worth less compared to the British pound than they were before you left on vacation. When you arrive home, you still have some British pounds left. So you go to your bank and use your remaining £100 to buy US dollars. If the bank gives you $179.31, each British pound is worth 1.7931 dollars. This is the exchange rate for converting pounds to dollars. But what if you were traveling to France? The currency used in France is the Euro. If you go to your bank and buy $1,000 worth of Euros with an exchange rate of 0.8064, how many Euros will you get?
Exchanging $1,000 for Euros with an exchange rate of 0.8064 means you will receive 806.40 Euros. Conversely, if you were living in France and planned a vacation in the United States, you would go to your bank to buy US dollars with Euros. If the exchange rate was 1.2403, how many U.S. dollars would you get for your 1,000 Euros? You would receive $1,240.30 for your 1,000 Euros.
Theoretically, you can convert the exchange rate for buying a currency to the exchange rate for selling a currency, and vice versa, by dividing 1 by the known rate. For example, if the exchange rate for buying British pounds with US dollars is .56011, the exchange rate for buying US dollars with British pounds is 1.78536. In other words, one divided by .56011 equals 1.78536. Similarly, if the exchange rate for buying US dollars with British pounds is 1.78536, the exchange rate for buying British pounds with US dollars is .56011 (or one divided by 1.78536 equals .56011). This is how newspapers often report currency exchange rates.
You should know, however, that you will not receive the price quoted in the newspaper if you trade forex. That’s because banks and other market participants make money by selling the currency to customers for more than they paid to buy it and by buying the currency from customers for less than they will receive when they sell it. This difference is called a spread and we’ll talk more about spreads later in this guide. As you can see, currency exchange rates fluctuate. Retail customers who trade in the forex market hope to profit from those fluctuations.