What is foreign exchange and how does it work?

Quick insights

• The exchange rate for many global currencies is determined by the foreign exchange market.
• Strategically using foreign currency, debit and credit cards on an international trip could potentially limit the impact of fluctuations in the exchange rate and minimize banking fees.
• Banks and financial institutions generally tend to offer the most favorable exchange rates.

What determines the exchange rate when you convert currency before a trip abroad? For many currencies, the exchange rates are determined by the foreign exchange market, which is a global marketplace. However, banks and financial institutions may add a markup when you exchange money or make a foreign transaction.

Let’s explore the fundamentals of how this market operates and how it might affect the cost of your next trip.

The basics of foreign currency exchange

Exchange rates may directly impact your spending power abroad. Here are some key terms to help you understand how currency exchange works:

• Foreign exchange: The process of converting one currency into another
• Exchange rate: The rate at which one currency is exchanged for another
• Currency pairs: The value of one currency relative to the value of another
• Foreign exchange market: A global decentralized marketplace where participants (usually banks, financial institutions, governments, corporations and traders among others) can buy, sell, exchange and speculate on the exchange rate of a currency pair. This marketplace determines the exchange rate for currencies all over the globe.

The foreign exchange market—also known as “forex” or “FX”—is the largest financial market in the world. In this market, currencies are always traded in pairs.

People who have a good understanding of how this market operates may be better equipped to decide when to exchange money and obtain more favorable exchange rates.

How to convert currency

Some websites offer online tools that show real-time exchange rates and currency conversion calculators. The exchange rate you get when exchanging currency, using a debit or credit card, or withdrawing from your checking or savings account at an ATM may differ from the rate you see reported online.

You can exchange currency at the following locations:

• Banks and financial institutions
• Currency exchange bureaus
• Mobile apps

In many cases, your bank will tend to offer you the best available exchange rate.

Card networks, like Visa and Mastercard, set the exchange rates for purchases made with their cards. Banks may then add a markup to these rates to help manage the risks associated with currency fluctuation. Choosing to pay in the local currency when making a transaction with your debit or credit card may get you a better rate. Keep in mind you may not always be given this option when making a purchase.

Researching any foreign transaction fees on your credit and debit cards before traveling to another country may help you avoid stress and unexpected charges on your bank statement.

How foreign exchange works

The foreign exchange market is made up of financial centers across the globe. The market functions to:

• Make currency conversions possible
• Hedge losses by allowing investors to lock in exchange rates through the use of futures and options
• Allow speculators to earn a profit trading

The market establishes the relative price of currencies for the global markets. As currencies are always traded in pairs, their values are relative to one another. This relative value or price will dictate how much of one country’s currency that the other can buy.

Prices in this market can be impacted by factors like supply and demand dynamics, political instability, economic indicators and market sentiment.

A strong currency might mean imports are cheaper and exports are more expensive. That’s how changes in foreign exchange rates can impact the global economy via trade balances, inflation and economic growth.

The advantages and disadvantages of foreign exchange

Before international travel, it may be helpful to know how currency exchange can impact you. Whether you’re converting cash or using your credit or debit card to make purchases abroad, each payment method has advantages and disadvantages. We’ve gathered some below.

Advantages

• You have several methods to exchange currency and make purchases in a foreign country.
• Many debit and credit cards allow you to make foreign transactions and have protections against unauthorized use.
• Converting cash to a foreign currency allows you to lock in an exchange rate, which may help with budgeting.
• Using a mix of payment methods—cash, debt and credit cards—may help you maximize the benefits and minimize the drawbacks of each payment method.
• You may be able to avoid foreign transaction fees on a credit or debit card by choosing to pay in the local currency when making a purchase. However, you may not always be given the option.

Disadvantages

• Debit and credit card use abroad may result in foreign transaction fees.
• The foreign exchange market is complex, making it difficult to predict the right time to exchange currency for favorable rates.
• If you’re using a debit or credit card, fluctuations in the exchange rate could potentially lead to a higher trip cost than you budgeted for.
• If you’re carrying cash abroad, it could be lost or stolen and recovering it may be challenging.
• There may be a minimum currency amount your bank or other currency exchange provider requires to exchange money.

In summary

When traveling internationally, the exchange rate is likely determined by the foreign exchange market, along with any markup added by banks, financial institutions or currency exchange bureaus. This global market is complex, but understanding it may help travelers identify favorable times to exchange money.

Banks and credit unions often provide the most favorable exchange rates. Researching your options may help you locate the most cost-effective place to exchange currency. Each payment method for international purchases—cash, debit and credit cards—has its own advantages and disadvantages. Understanding how each works may help you limit the drawbacks when making purchases abroad.

Finally, researching any rates and fees associated with using debit or credit cards and making ATM withdrawals may help you avoid unexpected charges.