THE EXCHANGE RATE

 THE EXCHANGE RATE

• As all of us know, the term ‘Foreign Exchange’ refers to money denominated in a currency other than the domestic currency. Similar to any other commodity, foreign exchange has a price. The exchange rate, also known as a foreign exchange (FX) rate, is the price of one currency expressed in terms of units of another currency and represents the number of units of one currency that exchanges for a unit of another. 
• In other words, exchange rate is the rate at which the currency of one country exchanges for the currency of another country. It is the minimum number of units of one country’s currency required to purchase one unit of the other countries currency. It is important to note that the value of a currency is relative as it is always given in terms of another currency.
• There are two ways to express nominal exchange rate between two currencies (e.g. the US $ and Indian Rupee) namely direct quote and indirect quote. The direct form of quotation is also called European Currency Quotation whereas indirect form is known as American Currency Quotation. A direct quote is the number of units of a local currency exchangeable for one unit of a foreign currency. The price of 1 dollar may be quoted in terms of how much rupees it takes to buy one dollar. 
• For example, ` 66/US$ means that an amount of Rs 66 is needed to buy one US dollar or ` 66 will be received while selling one US dollar. An indirect quote is the number of units of a foreign currency exchangeable for one unit of local currency; for example: $ 0.0151 per rupee. A quotation in direct form can easily be converted into a quotation in indirect form and vice-versa. This is done by taking the reciprocal of the given rate.
• An exchange rate has two currency components; 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. As the US dollar is the dominant currency in global foreign exchange markets, the general convention is to apply direct quotes that have the US dollar as the base currency and other currencies as the counter currency.
• There may be two pairs of currencies with one currency being common between the two pairs. For instance, exchange rates may be given between a pair, X and Y and another pair, X and Z. The rate between Y and Z is derived from the given rates of the two pairs (X and Y, and, X and Z) and is called ‘cross rate’. When there is no difference between the buying and the selling rate, the rate is said to be ‘unique’ or ‘unified’. 
• But, in practice, it is rarely so. . There are generally two rates – selling rate and buying rate – for any currency when one goes to exchange it in the market. Selling rate is generally higher than the buying rate for a currency. This is the commission of the money exchanger (dealer) to run its operations.