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How Are Foreign Exchange Rates Calculated?

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What Is Money Worth

Right now as I write this, it takes $1.27 to buy €1.00 (yes, I'm aware that they write it differently). The only way to determine what a currency is worth against a different currency is to have exchange rates. Some money units are more valuable than others.

For example, right now a euro is worth more than a US dollar (or an Canadian dollar for that matter). Edit: This is of course no longer true. Keep reading, the article is still valuable even if the exchange rates are dated.

Fair enough. So how do you calculate it?

Simple Division

Go to oanda.com. Find the table that lists the currencies. Let's say you want to know how many much of a euro you get for a US dollar. You find the line that says €1 is $1.27. Take the 1.27 and divide by one like this.

1/1.27=0.78. So $1.00 equals €0.78. See, not so hard.

Stabilization

What is it that hold all the currency rates equal with each other? In other words, how is it that if you exchanged 5 US dollars for Swiss francs, and then exchanged the francs for Mexican Pesos before finally exchanging the Pesos for US dollars again, you would end up with $5? (That is exactly what would happen, except that you would be out transaction costs).

It works that way because of arbitrage. Arbitrage is buying something and then selling it back for more than you bought it for. People actually have computers programmed waiting and looking for arbitrage situations and instantly take advantage. They are the ones who hold everything in line.