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The Principles of Exchange Rates

What is Exchange Rate?

In finance, exchange rate, also known as foreign-exchange rate, forex rate, ER, or FX rate is the rate between two currencies wherein one currency will be exchanged for another. It is also regarded as the value of one country’s currency in relation to another currency.

Exchange rates are determined in the foreign exchange market, which is open to wide range of different types of buyers and sellers and where currency trading is continuous.

Base currency and Counter currency

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.

In most exchange rates, the base currency is the US dollar and the other currencies are the counter currency. But there are a few exceptions to this rule, such as the euro and the Commonwealth currencies like the British pound, Australian dollar and New Zealand dollar.

Most of major currencies’ exchange rates 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.

US$1 = C$1.1050. In this example, the base currency is the U.S. dollar and the counter currency is the Canadian dollar.

Direct and Indirect Quotation

In the foreign exchange market, a currency pair is the quotation of the relative value of a currency against the unit of another currency. The quotation EUR/USD 1.3225 means that 1 Euro will buy 1.3225 US dollars. In other words, this is the price of a unit of Euro in US dollars. Here, EUR is called the “Fixed currency”, while USD is called the “Variable currency”.

Quotation using a country’s home currency, let’s take EUR 0.8989 = USD 1.00 in the Eurozone as an example, as the price currency is known as direct quotation or price quotation and is used in most countries.

Quotation using a country’s home currency as the unit currency, USD 1.11 = EUR 1.00 in the Eurozone for example, is known as indirect quotation or quantity quotation and is used in British newspapers; it is also common in Australia, New Zealand and the Eurozone.