How Does Foreign Currency Exchange Work?

Exchanging foreign currency means trading one type of money, such as the U.S. dollar, for another, such as the Euro. Since both types of currency can be used to purchase goods and services in different areas of the world, a currency exchange must be made if one plans to travel in an area that does not accept their home country's currency as payment. Another individual in a foreign country would likely not want to exchange money for a traveler into a currency they cannot use readily, which is why exchanges are made through larger institutions such as banks, hotels or major retailers.

When making a currency exchange, a person can use cash, traveler's checks or even ATM machines in the foreign country. The most important part of making a currency exchange is the current exchange rate--the amount of the foreign currency you can purchase for each unit of your home currency. Exchange rates fluctuate over time due to changes in the global market, and are based on the desirability and purchasing power of the currency. For instance, if I can buy a TV in the United States for $1,000, and the same TV in Japan costs 100,000 yen, a basic estimate for the exchange rate would be $1r=100 yen. Many factors can shift the exchange rate away from direct purchasing power equivalence, however, such as political instability, government monetary policy, interest rates and trade balance.

Banks and larger institutions are willing to trade one currency for another because each has the ability to hold and easily exchange the currency later at a better rate. Whenever an individual uses one of these exchanges, they will not exchange at the actual current exchange rate, but a rate slightly below the real rate. That is, if the dollar is trading at 1 for 100 yen at the real current rate, the bank might only give you 95 yen for every dollar--essentially a small fee on the transaction. Oftentimes, using an ATM machine will give an individual a better exchange rate than using a human teller, but machines often charge withdrawal fees themselves.