Every day, individuals and institutions need to swap one country's currency for another. The transaction may be made by a tourist so she can go shopping while on vacation or involve the transfer of millions of dollars by a giant multinational corporation as a routine part of doing business. In each case, the currency you start with will buy a certain amount of the other currency. How much you can buy is determined by the exchange rate between the two currencies.
The goods and services in any country are priced, bought and sold using that country's currency. If you are from another country you'll need to exchange your currency for that country's currency to make a transaction. The currency exchange rate tells you how much of one currency you can buy with another. For example, if you travel to Europe you'll need to buy euros with your U.S. dollars. How many euros you can buy depends on the exchange rate.
Because each currency is different, each pair of currencies has its own exchange rate, which you can find quoted on foreign exchange and financial websites. Quotations follow a standardized format in which the first currency listed is the "base currency," followed by the second currency. This is followed by a ratio that tells you how many units of the second currency it takes to buy one unit of the base currency. For example, the euro and U.S. dollar are quoted like this: EUR/USD = 1.2500. This means that at the time of the quote it took 1.25 US dollars to buy 1 euro. Occasionally, you'll see this reversed to state how many euros it takes to buy $1. The above example in reverse order would look like this: USD/EUR= 0.8000 (0.80 euro buys 1 U.S. dollar).
Currency exchange rates are not constant. On a day-by-day (and even minute-by-minute) basis, they fluctuate in response to foreign currency trading, economic forces and news events. The most important factors influencing currency exchange rates are international trade, monetary policy, the state of a country's economy and political stability. If demand for a country's goods is strong, people start buying more of that country's currency in order to purchase those goods. When demand for the currency goes up, its price (exchange rate) goes up. Interest rates and other aspects of a country's monetary policy affect currency exchange rates by changing the amount and cost of money available. Political instability or economic problems tend to drive a currency's exchange rate down by reducing demand for a country's exports.
For individuals, exchanging currency can be expensive. When you travel, you'll find most banks and hotels will be only too happy to exchange your dollars for the local currency — and charge a stiff transaction fee. Then you have to pay again to exchange any leftover currency back to dollars. Savvy travelers make arrangements ahead of time to avoid this expense. For example, you can open an account with the U.S.State Department's Federal Credit Union and exchange currency without a transaction fee, and with a guarantee you'll be able to change the money back at the same exchange rate (see link in Resources).
Large institutions and small traders exchange huge amounts of currency each day on the foreign exchange (Forex) market. This is where banks, companies and governments make the same currency exchanges a tourist makes but on a much larger scale. Currency exchange rates are set here by the process of traders seeking the best prices as they trade money back and forth. The bulk of the volume on the Forex market is actually generated by speculators (from individuals to large hedge funds) who buy and sell currencies in an effort to make a profit off the fluctuations in exchange rates.