Exchange rate

When residents of one country trade with residents of another country, they must generally convert funds between the currencies of the two countries to facilitate payments. Currency conversion requires a rate to define the value of one curren­cy in terms of another currency. This rate is the exchange rate.

Since multinational companies trade in many different foreign markets, that’s why portions of their revenues and costs are based on foreign currencies. Among the currencies regarded as being major (or ‘Hard’) are the British pound, the Swiss franc, the Deutsche mark, the French franc, the Japanese yen, the Canadian dollar and the US dollar. The value of two currencies with respect to each other is foreign exchange rate.

For the major currencies, the existence of a floating relationship means that the value of any two currencies with respect to each other is allowed to fluctuate on a daily basis. On the other hand, many of the nonmajor currencies of the world try to maintain a fixed (or semi-fixed) relationship with the respect to one of the major currencies, or some type of an international foreign exchange standard.

On any given day, the relationship between two of the major currencies will contain two sets of the figures, one reflecting the spot exchange rate (the rate on the date), and the other indicating the forward exchange rate (the rate at some specified future date).

Two widely used systems of quoting exchange rates are known as European terms and American terms of quotation. In European terms, the value of the U.S dollar is expressed in terms of all other currencies. In American terms, the values of all foreign currencies are expressed in terms of U.S. dollars. American terms of quotation are commonly used in many retail currency transactions. In their dealings among themselves, banks use European terms of quotation except for quotes on the British pound, the Irish punt, the Australian dollar, and the New Zealand dollar. These currencies have been traditionally quoted in American terms. The Wall Street Journal reports daily exchange rates in both European terms and American terms.

Exchange rates between pairs of currencies that do not involve the U.S. dollar such as the rate between the German mark and the Swiss franc, are known as cross rates. The common practice of quoting exchange rates in either European or American terms requires an additional calculation to obtain cross rates from these quotations.

Consider the following quotes (in European terms) of Deutschemarks and Swiss francs against the U.S. dollar:

DM1.6240/$ and SF1.4625/$

The cross rate of the DM against the SF is obtained by dividing the DM/$ rate by the SF/$ rate, as shown below:

DM/SF = (DM/$)/(SF/$) = 1.6240/1.4625 = DM1.1104/SF

This cross rate indicates that one Swiss franc is worth 1.1104 Deutschemarks.

1. What is exchange rate?

2. What are ‘hard’ currencies?

3. What does a floating relationship mean?

4. What are cross rates?

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