What Is an Exchange Rate?
An exchange rate tells you how much of one currency you get for another. Fluctuations can dramatically affect your costs and revenue.
Key Takeaways
- An exchange rate is the price of one currency expressed in another.
- Exchange rates fluctuate continuously based on economic and geopolitical factors.
- For businesses trading internationally, currency moves directly affect costs and revenue.
The basics
An exchange rate is the price at which one currency can be exchanged for another. If the GBP/USD rate is 1.27, one British pound buys 1.27 US dollars. If the rate moves to 1.20, the pound has weakened — you get fewer dollars for the same pounds. This affects anyone who buys or sells in a currency different from their home currency.
Who sets exchange rates?
Exchange rates in freely traded currencies are set by supply and demand in the foreign exchange market — the largest financial market in the world. Central bank interest rate decisions, inflation data, trade balances, political events, and investor sentiment all influence the rate. No single entity controls them.
Bid, ask, and mid-market rate
Every exchange rate has a bid price (what a bank or broker will buy the currency for) and an ask price (what they'll sell it for). The gap is the spread — the provider's profit. The mid-market rate is the midpoint between bid and ask — the 'true' rate you see on Google. Banks and card providers typically quote rates with a spread built in; specialist FX providers offer tighter spreads.
Why it matters for your business
If you import from China and pay in USD, a 5% strengthening of the dollar means your cost in GBP terms just rose 5% — potentially eliminating your margin on affected products. If you export to the US and invoice in USD, dollar weakness means your sterling revenue falls when you convert. Currency risk is a real and material business risk for any internationally trading SME.