Forex Rates: What They Are, How They Work, and Why They Fluctuate

The forex rate or exchange rate is a rate that shows how much the currency of one country is worth in comparison to that of another country. For example, when you receive an international payment from someone in a different country, the forex rate between the currencies of the two countries decides how much money you finally get in your currency.

The exchange rate is decided by the foreign exchange (forex) market. The demand and supply of a currency decide its value in comparison to other currencies. If the demand for a particular currency is high, its value rises. The forex rate significantly affects trade and international payments between two countries. 

There are different types of forex rates, as shown in the table below:

You can better appreciate the real-world impact of forex rates through these practical scenarios:

1. Travelling and Currency Exchange

When you travel to another country, you require their currency. The forex rate determines how much money in local currency you get. A favourable exchange rate allows you to have more money in the local currency, making your trip more affordable.

Forex rates shape travel choices and spending significantly. Countries with weaker currencies attract a lot of travellers due to travel and spending being cheap. 

2. Importing and Exporting Goods

Forex rates are crucial in international trade. When you sell goods to a different country, you get paid in the buyer's country's currency. If the buyer's currency is stronger than yours, you get paid more money. The scenario becomes the opposite for imports.

3. Cross-Border Business Transactions

For global businesses, forex rates directly impact costs and earnings. You must switch currencies when receiving payments from international buyers, paying international suppliers, or investing. Changing forex rates can make financial planning more challenging and impact your profits.

These practical scenarios illustrate how forex rates shape and impact global trade. By learning about these, you can handle international payments better and make smarter financial choices.

Forex rates change often. Economic and political factors influence them. Before we look into what leads to forex rate fluctuation, it's essential to clarify a few related technical terms, such as:

• Spot Rate: This is the current forex rate for immediate transactions.
• Currency Volatility: This is the extent to which forex rates fluctuate over time.
• Forward Rate: This is the fixed forex rate agreed upon for future transactions.

Now, let's take a look at the various factors that lead to forex rate fluctuations.

1. Economic Factors

• Inflation: Higher inflation lowers a currency's buying power, making the currency less appealing and reducing its foreign exchange value.
• Interest Rates: Interest rates determine how much return investors get. Hence, a higher interest rate makes the currency more appealing and increases its value in the foreign exchange market. 
• Economic Growth and Stability: Strong or growing economies typically have currencies with a high foreign exchange value. Furthermore, the currencies of unstable economies are not in high demand, which reduces their value.

2. Political Factors

Political events and global developments also significantly impact forex rates. Events such as elections, the introduction of new laws, or conflicts increase worry and risk, leading to a reduction in a currency's foreign exchange value. Positive political news, such as stable leadership or new trade agreements, tends to strengthen a currency.

3. Market Predictions and Investor Actions

Market predictions and investor action can impact the foreign exchange value of a currency, even in a stable economy. If investors think a currency's value is going to drop, they sell it on the forex market, lowering its demand and value. In contrast, if they believe a currency will appreciate, it fuels demand and increases its value.

So why should you, as a receiver of international payments, worry about forex rates? The answer can be summed up in one word: earnings. Let's understand this with an example:

Suppose you are an IT exporter, and you make a deal with a US-based client regarding a tech project. However, the client will pay you only after the six-month project duration is over. Now, if the Indian rupee depreciates during that period, you can see your profits diminishing. If this happens year after year (the unpredictability of forex rates due to several factors discussed above ensures that it's not a one-off thing), your overall earnings reduce significantly.

Here are four effective strategies you can use to prevent forex rate volatility from impacting your earnings:

1. Monitor the Currency Markets Regularly

Keeping abreast of the forex rate fluctuation can help you identify the most optimal time for receiving payments, ensuring that you benefit the most from favourable forex rates.

2. Encourage Early Payments

Certainty is best when it comes to financial planning. Wherever possible, enter into early payment terms with your international clients to mitigate forex risk and avoid being caught by surprise when the final payment comes out to be lower than expected.

4. Use Strategic Contracts

Using two special contracts called forward and spot contracts, you can mitigate forex risks significantly. A forward contract allows you to receive payments at a pre-agreed forex rate, while a spot contract allows transactions at the current market rate. A combination of the two is a potent financial planning tool.

4. Streamline Payment Solutions

Automating your international payment process via a payment platform like Xflow can help you streamline international payments without falling prey to hidden markup and transaction fees.

Xflow does not charge a forex markup fee and provides the best FX rates in the market. Here’s a table comparing Xflow and other payment platforms with respect to forex markup:

If your business receives international payments, understanding foreign exchange rates and their impact on your earnings is essential. Forex rates fluctuate depending on several economic, political and other factors. By utilizing the strategies given here, you can protect your earnings from fluctuations in the forex market. 

For further bullet-proofing your international payments against forex volatility, consider Xflow. With Xflow, your international payments become predictable, and your financial decisions become prudent. Here's how:

With Xflow, you can lock the current forex rate for up to 45 days to protect your business from forex volatility. With a flat transaction fee model, Xflow eliminates any hidden markup fees, further safeguarding your earnings. Free e-FIRA processing for streamlined compliance is a real cherry on top.