What is an 'Exchange Rate'

An exchange rate is the price of a nation’s currency in terms of another currency. Thus, an exchange rate has two components, the domestic currency and a foreign currency, and can be quoted either directly or indirectly. In a direct quotation, the price of a unit of foreign currency is expressed in terms of the domestic currency. In an indirect quotation, the price of a unit of domestic currency is expressed in terms of the foreign currency. Exchange rates are quoted in values against the US dollar. However, exchange rates can also be quoted against another nations currency, which are known as a cross currency, or cross rate.

BREAKING DOWN 'Exchange Rate'

An exchange rate has a base currency and a counter currency. In a direct quotation, the foreign currency is the base currency and the domestic currency is the counter currency. In an indirect quotation, the domestic currency is the base currency and the foreign currency is the counter currency. Most exchange rates use the US dollar as the base currency and other currencies as the counter currency. However, there are a few exceptions to this rule, such as the euro and Commonwealth currencies like the British pound, Australian dollar and New Zealand dollar.

Exchange rates for most major currencies are generally expressed to four places after the decimal, except for currency quotations involving the Japanese yen, which are quoted to two places after the decimal.

Furthermore, exchange rates can also be categorized as the spot rate – which is the current rate – or a forward rate, which is the spot rate adjusted for interest rate differentials.

Let’s consider some examples of exchange rates to enhance understanding of these concepts.

  • US$1 = C$1.1050. Here the base currency is the US dollar and the counter currency is the Canadian dollar. In Canada, this exchange rate would comprise a direct quotation of the Canadian dollar. This is easy to understand intuitively, since prices of goods and services in Canada are expressed in Canadian dollars; therefore the price of a US dollar in Canadian dollars is an example of a direct quotation for a Canadian resident.
  • C$1 = US$ 0.9050 = 90.50 US cents. Here, since the base currency is the Canadian dollar and the counter currency is the US dollar, this would be an indirect quotation of the Canadian dollar in Canada.
  • If US$1 = JPY 105, and US$1 = C$1.1050, it follows that C$1.1050 = JPY 105, or C$1 = JPY 95.02. For an investor based in Europe, the Canadian dollar to yen exchange rate constitutes a cross currency rate, since neither currency is the domestic currency.

Floating v Fixed

Exchange rates can be floating or fixed. A floating exchange rate is where a currency rate is determined by market forces. This is the norm for most major nations. However, some nations prefer to fix or peg their domestic currencies to a widely accepted currency like the US dollar. Reasons for fixing an exchange rate can be to reduce volatility or better manage trade relations. For example, Saudi Arabia pegs its currency, the riyal, to the U.S. dollar because its main export is oil, which is priced in U.S. dollars. 

 

 

 

RELATED TERMS
  1. Indirect Quote

    An indirect quote is a currency quotation in the foreign exchange ...
  2. European Currency Quotation

    A European currency quotation is an indirect quotation in the ...
  3. Quote Currency

    The quote currency is the second currency in both a direct and ...
  4. Base Currency

    The first currency quoted in a currency pair on forex. It is ...
  5. International Currency Exchange ...

    An international currency exchange rate is the rate at which ...
  6. Counter Currency

    The counter currency is the second currency in a quoted currency ...
Related Articles
  1. Trading

    Understanding the spread in retail currency exchange rates

    Understanding how exchange rates are calculated and shopping around for the best rates may mitigate the effect of wide spreads in the retail forex market.
  2. Trading

    Drastic Currency Changes: What's The Cause?

    Currency fluctuations often defy logic. Learn the trends and factors that result in these movements.
  3. Trading

    Top 5 Hardest-Hit Currencies

    The value of a country's currency is dependent on many factors that will cause it to fluctuate, relative to other world currencies.
  4. Trading

    Using interest rate parity to trade forex

    Learn the basics of forward exchange rates and hedging strategies to understand interest rate parity – fundamental knowledge for foreign-currency traders.
  5. Investing

    Currency Positions You Can Take Now

    The foreign currency market is the largest financial market in the world, and investors in this market have many options.
  6. Personal Finance

    The Worst Place to Exchange Currency

    Exchanging currency is a necessary part of traveling, but not all currency exchanges are created equal.
  7. Investing

    What Is A Currency War And How Does It Work?

    We look at what a currency war is, what factors may lead to it, the impacts of such a strategy, and whether there is a currency war currently.
  8. Investing

    Will the Yuan Become an International Reserve Currency?

    Although still a matter of when, China is likely to reach a significant milestone when the International Monetary Fund decides to include the Chinese yuan in its special drawing rights basket ...
RELATED FAQS
  1. Why isn't the EUR/USD currency pair quoted as USD/EUR?

    In a currency pair, the first currency is called the base currency and the second is the quote currency, a longtime convention ... Read Answer >>
  2. Why is the U.S. dollar shown on the top of some currency pairs and on the bottom ...

    All currencies are traded in pairs. The first currency in the pair is called the base currency while the second is called ... Read Answer >>
  3. How do national interest rates affect a currency's value and exchange rate?

    Generally, higher interest rates increase the value of a given country's currency, but Interest rates alone do not determine ... Read Answer >>
Hot Definitions
  1. Inflation

    Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
  2. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  3. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  4. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  5. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  6. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
Trading Center