An exchange rate is the price of one currency, in terms of another currency. When we’re trading across national borders, we use these rates to work out how much what we’re trading is worth in the other country’s currency.
Between World War II and the early 1970s most countries in the world had a system of fixed exchange rate. The United States decided that a dollar was worth a certain amount of gold, and everything else was fixed in relation to the dollar. It kept things simple and stable—countries had to get international approval if they wanted to change how many dollars their currency was worth, and there were rules against moving money around too quickly.
The problem was, the US had to have a lot of gold on hand to keep the price fixed. By the early 1970s, the American’s started to run out of gold, and the system fell apart. Now, most countries in the world have adopted floating exchange rates, which aren’t fixed to anything. These rates change depending on who wants how much of which currency. This is all a bit stressful for individuals and companies. The prices of difference currencies can change every hour—think of the digital prices at a currency exchange booth in an airport or train station. It’s stressful enough when you’re going on vacation, but it can be disastrous when you’re trying to make massive business deals across borders.
To cope with the uncertainty, people came up with what are called currency derivatives. Currency derivatives are contracts that allow companies or investors to trade one currency for another at a specific date in the future. This allows companies and investors to reduce the risk of an exchange rate moving in the wrong direction. But if a lot of traders are making bets on where the exchange rates will go, some economists think they can actually affect the final exchange rate.
This might all sound distant if you’re not planning on going somewhere with a different currency, but exchange rates directly affect everything you buy from another country. So next time you’re sipping coffee or eating a banana, know that exchange rates helped decide how much you paid.