Understanding Foreign Exchange Rate

In order for you to know how much the value of two currencies compared with each other, you should know its foreign exchange rates. Let us take for example; the foreign exchange rate of the Euro to the United States dollar is 0.65, which means that 0.65 euro is equivalent to 1 US dollar.

The foreign exchange rate can also be categorized into two types: a) the spot exchange rate which usually refers to the current foreign exchange rate; b) the forward exchange rate, which is the foreign exchange rate of a currency quoted today but will be paid on a specific future date.

Foreign Exchange Rate Quotes

If you are dealing in the international money transfer market, you should be able to understand how the currency is being quoted so that you would be able to get the cheapest / low cost / free money transfer services, either local or international, and online or through a financial institution. Foreign exchange rates quotation is provided by stating the number of “term currency” or the “price currency” which can be bought in terms of 1 unit currency which is also called the base currency.

So, if you are given an international money transfer quote of say, EURUSD exchange rate is 1.3, this means, that the value of the US dollar is 1.3 per Euro. From the EURUSD example, the USD is the term currency while the Euro is the base currency. Be sure to be able to know this so that you would have an idea when you will be availing of an international money transfer services.

Market Convention

In the foreign exchange rate market, there is a convention that determines which should be the base currency and the term currency. Usually, the order is as follows: Eur – GBP – AUD – USD – xxx (where xxx is any of the other currencies). Hence, by following the order, if you want to convert EUR into AUD, then your base currency should be the EUR while the AUD is your term currency. From this convention, it would tell you how many Australian dollars you would need to pay for 1 euro. There are also markets in Europe that the EUR is quoted as the term currency while the GBP is the base currency.

If in instances that both of the currencies are not listed, determining the base currency will be decided on the foreign exchange rate that would result to greater than 1.000 value. This is intended to avoid rounding off the foreign exchange rates, as well as having foreign exchange rates that would exceed the 4 decimal places standard. However, there is an exception to this rule since the Japanese yen often quote their currency as the basis to other currency.

Aside from the standard foreign exchange rate quote, there is also what they call as direct quotation, and indirect quotation. Direct quotation refers to a quote where the country’s home currency is used as the price currency while the indirect quotation uses the country’s home currency as the unit currency. The indirect quotation is common in Australia, New Zealand, and the Euro Zone.

For a currency pair such as the EURUSD, the EUR is the base currency while the USD is the term currency. Thus if you are given EURUSD = 1.55, this means that 1 EUR = 1.55 USD. Usually, the currency pair has a slash “/” inserted in between. If a slash is present, the currency pair should be inverted, hence, the foreign exchange rate should be USD/EUR = 1.55. With this example, the EUR is still your base currency while the US is your price/term currency.

In the 1980s through 2006, market convention dictates that the currency pairs should be quoted with four (4) decimal places for spot exchanges while up to six (6) decimal places for swaps. The fourth decimal place is called the “pip”. An exception of the decimal place convention is when the value is less than 1.000. However, in 2006, Barclays Capital started offering foreign exchange rates with 5 or 6 decimal places. It was said that the reduction of the spread (the difference between the buy and sell rates) compelled the pricing to be finer.

Free Currency or Pegged

For a free currency or free floating currency, its foreign exchange rate varies from time to time against the other currency. The variation is determined by several market factors including the force of supply and demand. Free floating currencies constantly changes as they are quoted in the financial markets.

A pegged currency is a currency system wherein the foreign exchange rates are fixed. An example was the United Arab Emirates UAE Dirham. The currency is currently pegged to the US dollar hence fixing the foreign exchange rate of the UAE dirham to 3.65 Dirham per US dollar.

Foreign Exchange Rates Fluctuations

The foreign exchange rate of two currencies will actually change when one currency will become more valuable especially if the demand of such currency is greater than the supply. Consequently, the value of the foreign exchange rate will fall if the supply is more than the demand.

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