a. The foreign exchange (FX) market is the market for trading currencies against each other.
b. The FX market is the world’s largest market that facilitates world trade.
c. The FX participants do not only buy and sell currencies needed for a trade but also transact to reduce risk (hedge) and speculate on currency exchange rates.
d. An exchange rate is the price of a country’s currency in terms of another country’s currency.
e. The currencies across the world are referred to by their ISO code. Some of the major currencies and their respective ISO codes are:
i. USD: US Dollar
ii. EUR: Euro
iii. GBP: Great Britain Pound
iv. JPY: Japanese Yen
v. CAD: Canadian Dollar
vi. AUD: Australian Dollar
vii. ZAR: South African Rand
viii. INR: Indian Rupee
ix. MXN: Mexican Peso
f. The exchange rate is the number of units of one currency (the price currency) that one unit of another (the base currency) will buy.
The exchange rate is mostly quoted in the term A/B, which is the number of units of currency A (i.e. the price currency) that one unit of B (i.e. the base currency) will buy.
For example, a quote of GBP/USD of 1.3543 would mean that $ 1.3543 can buy ₤ 1. If this exchange rate falls to 1.3530, it would mean that it would now require fewer dollars, i.e. $ 1.3530 to buy ₤ 1. That means that the value of the US Dollar has appreciated and that of the British Pound has depreciated.
g. The foreign exchange rate could either be quoted directly or indirectly.
i. The direct quote, which is denoted by Sd/f, is the quotation where one unit of foreign currency is quoted in terms of the local currency.
For example, if I am a resident of the United States, and I am interested in the USD and GBP quotation, the direct quote will be USD/GBP, i.e. one Pound quoted in terms of US Dollars.
ii. An indirect quote, on the other hand, which is denoted by Sf/d, is the quote where one unit of local currency is quoted in terms of the foreign currency.
Thus, in the above case, one Dollar quoted in terms of the British Pound is an indirect quote for the US resident. It can be calculated by inverting the direct quote (i.e. dividing the direct quote by one).
iii. There are a number of conventions, which simply refer to a particular exchange rate.
A few examples of such quotes are:
FX Rate Quote Convention |
Name Convention |
Actual Ratio (Price currency/Base currency) |
EUR |
euro |
USD/EUR |
JPY |
dollar-yen |
JPY/USD |
GBP |
sterling |
USD/GBP |
h. The dealers always quote a bid (at which the dealer will buy) and an offer price (at which the dealer will sell). And, it should be noted that the bid rate is always greater than the offer price.