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Exchange Rates Explained

The Cost of Money

Exchange Rates Explained
0 Comments 11 November 2010
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Most people know what an exchange rate is; travelers know better, and economists know best.  But really wrapping your head around the concept can be trickier than most let on.  We’re not going to get deep into the workings of the foreign exchange market but instead will try to help you make sense of the numbers you see at the currency exchange kiosks on every corner of a tourist area.

The first thing you notice about every exchange kiosk, not counting the big names at the airport, is that they all tout signs saying “NO FEE! or “Commission Free!”  Don’t be fooled; they have to make their money somehow.  The exchange rates they offer have the fees built in.

There are a lot of currency conversion tools out there (see iPhone Apps – Essential Travel Apps) but I tend to rely on Google for quick and easy reference.  Searching for “USD to Thai Baht” or “EUR to Indian Rupee” will give you the most current rate.  You’ll soon notice that the number Google gives you will be higher than the one you see listed at the exchange kiosks on the street.  The difference determines the profit they make on your conversion.

But what do those differences mean anyway?  Sure, typing “USD to Peso” in Google will tell you how many Pesos your dollar is worth (12.35), but what happens when that number is higher or lower?  And why do the kiosks always have two columns, one for BUY and one for SELL?

I find the easiest way to grasp differences in exchange rates is to think of an ATM.  Say your bank account is in the US, denominated in US Dollars, and has $100 in it.  When you go to an ATM in Israel and ask for your balance, it responds in shekels based on the current exchange which, when I arrived there, was 3.5.  The account balance indicated on the receipt is therefore 350 shekels.  Assuming you don’t take any money out and there’s no interest earned that account will still have $100 tomorrow and $100 the next day as well.  But when the USD to NIS exchange rate suddenly changes to 4, as was the case about a month later, your account magically goes from 350 to 400 shekels.  Congrats.  You just got richer.

Now look around you.  A cup of coffee, that falafal pita, and your yoga class all cost the same as they did the day before.  For those living in Israel who don’t happen to be buying anything from an American on eBay that day, nothing has changed.  If the new exchange rate sticks (it didn’t) then, in time, some of those local prices should gradually change as the new cost of American imports ripples through the economy, but certainly not while you’re there.  No, there’s no downside here, just enjoy the free money. Buy yourself something nice for 50 shekels.

But keep in mind the opposite can happen too.  Exchange rates are correlated with all sorts of world events and can swing wildly based on speculators.  Again, locals don’t usually feel these swings unless they’re prolonged but, as a foreigner in a foreign land, you sure will.  After India’s general election in April ’09 yielded better results than expected in the eyes of the global investment community, the Indian rupee gained with respect to the US dollar and my ATM slip reported that some of my funds had magically disappeared.  Bummer.

Another way to look at differences in exchange rates is in terms of prices.  This works best when considering the prices of basic items that should cost about the same in comparable economies, like bottled water.  If, after converting the price of a bottle of water in Australia to USD, you find it to be considerably more than you’d pay in the US, say 2 bucks for a half-litre instead of 1, you can bet that the USD to AUD exchange rate is lower than normal.  It’s not like water costs that much more in Australia.

How about the BUY and SELL columns for each currency on display at the exchange kiosk?  The BUY column is how much local currency the kiosk is willing to pay to BUY the foreign currency from you.  For example, they’re willing to buy your crisp US Dollar bill for 4,000 Cambodian Riel.  The SELL column is how much local currency they’re asking to SELL you that foreign currency back.  They’ll sell you a US Dollar bill for 4,200 Riel.  At the end of the day they’re just buying and selling pieces of paper using their local currency.  The numbers aren’t equal because they’re trying to make a profit.  They’ll buy that dollar from you in order to sell it to the next guy at a higher price.  It is a business after all.

But, with the right planning, you won’t need the exchange kiosks anyway.  You can get the best rates possible easily and practically anywhere with the right ATM card.  Check out Finance on the Go to learn how!

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