CFM7011 - Understanding foreign exchange: exchange rates

What is an exchange rate?

The idea of an exchange rate is familiar to anyone who has been on holiday abroad. If you travel from a country where the pound sterling is legal tender to a country where, say, the US dollar is legal tender, you will need to exchange pounds for dollars, and so you will need to know how many dollars you will get for each pound.

An exchange rate is simply the price of a unit of currency used in one country or area expressed in the money of another country or area.

This can be achieved by one of the following three methods.

Direct quotation

From the point of view of someone living in the UK, the price of each unit of foreign currency could be expressed in terms of the home currency, sterling. So, using the exchange rates at 15 April 2002, we could express the US dollar and euro exchange rates respectively as:

£0.6960 = $1, or £0.6960/$ and

£0.6122 = €1, or £0.6122/€

Indirect quotation

As a corollary to a direct quotation, we could express the value of each pound sterling in terms of the dollar, or the euro:

$1.4368 = £1, or $1.4368/£ and

€1.6332 = £1, or €1.6332/£

Cross exchange rate

A cross exchange rate is the value of one foreign currency expressed in another. For example, we can deduce from the above figures that if $1.4368 and €1.6332 are both worth £1, then:

• €1 must be worth $0.8797 (1.4368/1.6332)
• $1 must be worth €1.1366 (1.6332/1.4368)