How do exchange rates work?

Currency exchange rates are part and parcel of holidays abroad. But have you ever wondered how exchange rates work? Having a better understanding of exchange rates could help you get a better deal on your holiday money.

Yet according to research from Travel Money Club, 75% of Brits don’t even know the foreign exchange rate before converting their currency, while 45% say they don't know where to get the best deal or if there are hidden commissions involved.

Jargon such as ‘market rates’ and ‘spreads’ can make currency exchange seem like a more complicated beast than it really is – strip away the lingo, and it’s all much more simple.

So, what are exchange rates?

When you exchange one country’s currency for another – such as exchanging pounds into euros because you’re going to France – you buy that foreign currency at the current rate. How this rate is determined depends on a number of factors, which we’ll look at in a bit more detail later.

If the rate of the euro to the pound is €1.09 to £1, this means that for every £1 you exchange, you will get €1.09 back. So, if you exchange £100, you should receive back €109.

In this case, the pound is the stronger currency, as you’re getting more more than one euro for each of your pounds.

What are commission fees?

Commission fees can make things a bit confusing.

Some exchange outlets charge a commission for making the exchange, which is usually a flat fee of a few pounds. Many outlets offer commission-free exchanges, but while this may sound great, no commission does not always equal better value – you need to do the maths to find out.

Here’s an example:

• Outlet A offers €1.20 for £1, with no commission fee. You give them £100 and receive €120 back.
• Outlet B offers €1.24 for £1, with a £3 commission fee. You give them £100 and receive €124 back, but are then also charged £3 for the exchange – so in total you have spent £103 to get €124.

So, at Outlet B the exchange rate is better, but you are charged a hefty commission fee – perhaps Outlet A is better value for money, even though the exchange rate is lower?

If you had exchanged that total of £103 at Outlet A instead, you would have received €123.60 in return. So, in this instance, you’re better off paying the commission fee that is charged at Outlet B.

Put simply, at Outlet A you’ve spent £103 to get €123.60, while at Outlet B you’ve spent £103 to get €124, so you’ve got back 40 cents more at Outlet B.

Obviously that’s not a lot of money, but the more you exchange, the higher the difference becomes. Other currencies may also give greater returns on the pound.

Note that you may also encounter other charges, such as handling fees. Ultimately, what you need to consider is this: How much currency will you receive, after all charges, in exchange for the total number of pounds that you spend?

Why do exchange rates change?

There are many political and economic factors that affect the worth of a country’s currency, such as inflation, interest rates and government policy.

While you might only worry about exchange rates in the run-up to your holiday, traders are constantly buying and selling currency, which also has an impact on its value. To understand how exchange rates work, you don't need to be an expert in economics but a basic grasp of such things will help.

Put simply, the more demand that there is for a currency, the higher it will be valued. If more people are selling a currency, its value will depreciate.

OK, fine – but when should I buy my holiday money?

There is no hard and fast rule as to when you should buy your holiday money as the rates are constantly changing.

However, often you’ll see steady trends developing, with the pound’s value heading either up or down. Generally, if the trend is going upwards – the pound starting to perform better against the euro, for example – you can leave buying your currency until later.

Conversely, if the pound’s value is dropping, you might want to think about exchanging sooner rather than later. Xe.com provides a live feed that you can use to track currencies against each other.

Nothing can be guaranteed, however! Sometimes, major global events can affect a currency dramatically, and a good example is the fortunes of the pound before and after the Brexit vote in 2016.

After the UK voted to leave the EU in June 2016, the value of the pound dropped dramatically. Investors started to shift their pounds due to the unpredictable nature of the currency, leaving the pound worth less.

What this meant was that if you spent £100 on euros the day before the Brexit vote, you’d get more euros back than if you spent £100 on euros the day after the vote.

This is quite an extreme example, however – currencies don’t usually change this dramatically or this quickly, unless a major event occurs.

The stronger the pound, the more foreign currency you’ll be able to buy, and the further your money will go while you’re on holiday – good news for thrifty travellers.

Why do different places offer different rates?

Credit: xe.com

You’ll have noticed that rates vary from vendor to vendor. Profit is one obvious reason for this difference, but processing and transfer fees are also often factored in.

Look out for the mid-market rate. This is the midpoint between the “buy” and “sell” prices of money – basically, the fairest exchange rate used by traders and for inter-bank transactions.

You can check the mid-market rate at Xe.com or Google – ideally, try to find an outlet offering the exchange rate closest to this. This handy tool from MoneySavingExpert.com also allows you to see where the best exchange rates are in relation to you.

Here’s a snapshot of pound to euro exchange rates taken on July 30, 2019 to highlight the difference*:

• Mid-market rate: 1.092
• Independent exchange bureau in London: 1.079
  
• Post Office: 1.071 (exchanges over £500)
• HSBC: 1.042

As a general rule, the airport is almost always the worst place to exchange your money. Once you’re here you become a captive audience, and the desks can charge what they like – make sure you sort out your currency before you get here.

* All rates are online rates and were accurate at the time of writing.