What Is an Exchange Rate?
An exchange rate tells you how much of one currency you need to buy a unit of another. A quote of EUR/USD = 1.10 means one euro costs $1.10; if the rate rises to 1.15, the euro has strengthened (appreciated) against the dollar, and the dollar has weakened (depreciated).
Most major currencies float, meaning their rates are set continuously by supply and demand in the foreign exchange (FX) market, the largest financial market in the world with trillions of dollars traded daily. Some countries instead peg their currency to another, as Hong Kong does to the U.S. dollar.
What Moves Exchange Rates
Interest rate differentials are the biggest driver: capital flows toward currencies offering higher yields, so when the Fed hikes while other central banks hold steady, the dollar tends to strengthen. Inflation, trade balances, economic growth, and political stability all feed into the price as well.
In the long run, exchange rates gravitate toward purchasing power parity, the idea that identical goods should cost the same across countries. In the short run, sentiment and capital flows dominate, and currencies can overshoot fundamentals dramatically.
Example
Suppose a U.S. investor buys a European stock for 100 euros when EUR/USD is 1.10, spending $110. If the stock is flat but the euro strengthens to 1.20, the position is now worth $120, a 9% gain purely from currency. The same math cuts the other way: a weakening euro would create a loss even if the stock never moved.
Why It Matters
Exchange rates flow directly through corporate income statements: a strong dollar shrinks the translated value of a U.S. multinational's foreign revenue, which is why earnings calls often cite 'FX headwinds.' Analysts frequently model constant-currency growth to separate business performance from currency noise.
For investors, currency is an unavoidable layer of return and risk in any international position, and many institutions hedge it with forwards or swaps. Central banks also watch exchange rates closely, since a weak currency raises import prices and can feed inflation.
