Written by 11:26 am Finance & Economics: Explained, Trending

Exchange Rates and Hot Tubs

For many people living abroad, exchange rates are a fact of life. After all, many of us have clients or even bank accounts in far away lands, paying our salaries in a different currency than the one we live in.  

Our article explains everything you need to know about how exchange rates work. As a bonus, you’ll also be inspired to seek out the nearest jacuzzi (at least that’s what happened to us while writing this piece)

Where the central bankers are glorified hot tub attendants.

To understand how exchange rates work, we need to quickly go over what central bankers do and their role as economic hot tub attendants.

Central banks sit at the center of any economy. Their job is to control the amount of money circulating at any given moment. 

This control is vital for a couple of reasons: 

  • To regulate inflation and deflation so that prices don’t rise or fall too fast. 
  • to get the economy moving when growth is slow.

If we think of the economy as a hot tub, they want to make sure that the economic temperature is just right.  And like hot and cold water regulating the jacuzzi, Interest rates are their main tool central bankers use to control the economy. 

When the economy grows too fast or gets too hot, they raise interest rates. When interest rates go up, two things happen: 

  • It costs more to borrow money, meaning that people and companies have less incentive to take out loans and;
  • Savings and deposit accounts become more attractive because their interest rate increases.

When the economy slows down or gets too cold, central bankers lower rates. By decreasing rates, people and companies will borrow more money (since it costs them less in interest), pumping money directly into the economy.  

Likewise, if savings accounts pay less interest, savers (in theory) invest their money in funds and other investments that pay better returns.  There are a lot more pieces at play here, but interest rates are at the core of every economy.

Central bankers in action.

So what does hot-tub macroeconomics have to do with exchange rates (also known as FX or Forex rates)?  

Each economy is different. Some do well when others don’t.  Various factors contribute to these differences, including taxes, government policies, and market performance.   

Because central bankers generally have to take care of their own hot tub and not those of others, temperatures — or rates — vary between countries.

The difference in rates between countries helps determine the exchange rate.  If country A has a higher interest rate than country B, investors in country B will exchange their money and deposit it in country A.  

The higher deposit rates create more demand for country A’s currency, driving up its price. 

Combined, the difference in both rates and demand creates the foundation of the exchange rate between the two economies. 

The best investors (and the ones who can sleep at night) invest within their risk tolerance. Do you know yours?

The temperature difference between economic hot tubs

So what does hot-tub macroeconomics have to do with exchange rates (also known as FX or Forex rates)?  

Each economy is different. Some do well when others don’t.  Various factors contribute to these differences, including taxes, government policies, and stock market performance. 

In fact, all of these pieces are interconnected. Well-managed economies tend to have robust stock markets and strong governance.  Investors around the world flock to them, looking for return.  Likewise, poorly-managed economies represent risk for investors, which makes them less attractive.

In any case, no two economies are equal. And, since central bankers generally have to take care of their own hot tub and not those of others, temperatures — or rates — vary between countries. The difference in interest rates set by central banks forms the foundation of exchange rates over the long  run

Big investors notice these differences.  A “carry trade” is a common investment strategy where investors in one country convert and deposit their money in another, where interest rates are higher. The idea is that they get a better return on their investment, even after taking into account the FX rate.

On a more day-to-day level other factors cause the exchange rate to move rapidly.  Stock markets around the world are some of the most accessible investment platforms.  If the stock market in the US is doing well, global investors will place their money there. To do so, they need to have dollars.  

When there’s tons of demand for dollars, its price versus other currencies — i.e. the exchange rate — goes up.  Likewise, if the US market does poorly, global investors sell their investments and convert their dollars back into their home currency. 

Additionally, international companies use different currencies to conduct their business. These could be manufacturers who buy and sell commodities priced in dollars or British pounds, or big travel agencies who have resorts around the globe. Regardless, each day, companies go to FX markets for their business needs. 

Finally, significant political events can impact exchange rates as they change investors’ perceptions on the direction of the economy.  For example, the Brexit referendum in June 2016 sent the British pound tumbling as investors worried about the negative impact of the UK leaving the EU. 

Put together, all of these factors make exchange rates what they are.  It should come as no surprise that currency markets are the largest in the world. Each day, over 5 trillion dollars worth of currency trades take place around the world, in a near non-stop hot tub party.

The hot tub of clown cars (i.e. how currency trading works)

If you’ve ever looked up an exchange rate, chances are that you came across some website offering you a currency trading platform.  They probably flash some catchy text explaining how you can trade currencies and make a quick profit (nevermind the disclaimers in the ad telling you otherwise). 

Currency traders are looking to exploit FX markets for quick profits. To do so, they work under a couple of assumptions: 

  • The central banks are not controlling the hot tub temperature properly and will make an adjustment soon. 
  • Short-term political acts will cause a sudden change in the exchange rate;
  • There’s some bozo who erroneously believes they know what they’re doing, which offers an opportunity for easy money (keep this one in mind).

The idea is that if you bet correctly, you can buy an undervalued currency and sell it for a higher profit once the exchange rate moves in your favor. 

Currency markets move quickly, and most traders make their profits within a short time frame, either within days or even hours or minutes. It’s a quick in/out operation that, in theory, leaves you with little risk (in theory being the key word here).

The currency trading platforms advertising to you will probably tell you that.  What they most likely aren’t telling you is the order of people making money on the FX market.  

That order is: 

  1. Large banks
  2. Institutional (i.e., professional) investment firms
  3. Hedge funds
  4. The currency trading platforms

You might notice that “retail trader” or “user of a currency trading platform” isn’t on that list.  Why? Because by the time the other guys move, there is no opportunity left for small individual traders.

In other words, the person using the platform is the clown in the hot tub, or “bozo” if you will.

I don’t want to speculate, but…

In addition to quick trading, traders can make a profit in the currency market through speculation. Here, investors will hold onto a currency for a longer time frame.  These people or, most likely, institutions, believe that entire economies have fundamental flaws. 

They take (very) large bets, hoping that they can capitalize on these misperceptions. Once the speculators are proved right, then bam! – profit time. 

Unfortunately, just like in short term trading, the order of who wins by speculating is exactly the same. 

As profit opportunities arise, more traders jump. Markets, by economic law, react, and the price difference or profit opportunity eventually goes down.  

By the time an individual currency trader could make a speculative gain, the person higher up the food chain already took it, and any potential gain is negligible, if even still there.

Likewise, if a person speculating on a currency isn’t making money from the interest rate (by saving the money), then he or she is losing out even more. 

For more info, please refer to this gif:

What people living abroad can do to manage exchange rates

For many people living abroad, exchange rates play a vital role in both day-to-day and long term finances.  Of course, each person’s needs are different, and what works for one person might not work for another. 

For some expats, there could be an investment goal in a different currency.

For many digital nomads and remote workers, though, invoicing in one currency and spending in another is a fact of day-to-day life. Here, using a transparent exchange platform like TransferWise, CurrencyFair, or other companies specialized in money transfer is probably a safe choice.  

If you absolutely feel confident playing the markets, only do so with money you’re ready to lose, or, at the least have a back-up hedging plan to protect yourself. 

Generally, though, people abroad should avoid actively trading and speculating on currencies.There’s absolutely no guarantee or even any way to predict or control FX markets.    This short-term goal is gambling at best and catastrophic at worst.  The Bigger fish eat the little ones, and you’re most likely in the latter category. 

Our advice if you want to play in the water?  Find yourself a nice hot tub and relax.

Editor’s note: this article was originally published in October 2019. It was revised in June 2020.

Abroaden is a company for expats, digital nomads and other world citizens looking for low-cost and transparent financial advice and investment management.