Foreign currency markets and exchange rates

Whenever a U.S. firm purchases goods or services from a firm in another country, two currencies normally are involved. For example, when a U.S. company purchases materials from a British supplier, the British firm usually prefers payment in British pounds, whereas the U.S. company prefers to make payment in U.S. dollars. If the sales agreement requires that payment be made in pounds, the U.S. company will have to exchange (that is, sell) dollars to obtain the required number of pounds. The exact amount of dollars the U.S. company will have to sell depends on the exchange rate between the two currencies.

Suppose, for example, that the exchange rate at the time of the transaction is $1.48 per pound, £. Furthermore, assume that the British supplier and the U.S. firm have agreed on a price of £2 million for the materials. Therefore, the U.S. firm will have to exchange $2.96 million (that is, £2,000,000 x $1.48/pound) to obtain the British currency to pay for the purchase.

Foreign currency needed for international financial transactions can be exchanged for domestic currency in most countries either at large commercial banks or at a central bank operated by the government. The volume of foreign currency transactions is very large. For example, in 1990 the Bank for Interna­tional Settlements estimated that daily, worldwide foreign currency trading totaled over $640 billion. Of this amount, nearly 60 percent was between international banks; about 25 percent was between banks within a country; and the balance was with foreign currency dealers and other banking customers.

The most important foreign currency trading centers are in New York, Tokyo, Hong Kong Singapore, Bahrain, Frankfurt, Zurich, London, San Francisco, and Los Angeles.

Direct and Indirect Quotes

Exchange rates can be expressed either as direct quotes or indirect quotes. A direct quote is the home currency price of one unit of foreign currency. For example, from the perspective of a U.S. firm a quote of $0.58 per Deutsche mark (DM) would be a direct quote. An indirect quote is the foreign currency price of one unit of the home currency. A quote of DM1.7241/$ would be an indirect quote from the perspective of a U.S. firm. Direct quotes and indirect quotes have a reciprocal relationship. Accordingly, the indirect quote was derived by taking the reciprocal (1÷$0.58/DM) of the direct quote

Table 3 — 2 Spot Foreign Exchange Rates

Source: Wall Street Journal (March 4, 1986 and December 2, 1991)

Country	Currency	EXCHANGE RATE (U.S. DOLLARS)
		March 3, 1986	December 1, 1993
Australia	Dollar	$0.6955	$0.6588
Britain	Pound	1.4465	1.4775
Canada	Dollar	0.701 5	0.7500
France	Franc	0.1467	0.16829
Germany	Mark	0.4517	0.5807
India	Rupee	0.0810	0.0312
Italy	Lira	0.000664	0.0005816
Japan	Yen	0.005571	0.009191
Netherlands	Guilder	0.3987	0.5178
South Africa	Rand	0.020	0.2967
Sweden	Krona	0.1395	0.1177
Switzerland	Franc	0.5330	0.6658
—	ECU	0.9667	1.11620