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 nation's currency, which is 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 the 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.
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.