What are Exchange Rates?

“Exchange rates is an amount of the domestic currency you will have to pay to obtain a
unit of a foreign currency.” .
Imagine for a moment that the new year is just around the corner. You have finally been able to
approve your vacation leave from your boss, and you have painstakingly managed to accumulate
the savings needed to go backpacking across Europe. Like an arrow shot from a bow, you take
the first flight out and finally land on European land. The flight was long, and you felt famished
and looked for a Subway at the airport. Having custom-made your own lip-smacking Sub, you
pull out a wad of dollars and slide it across the counter to make the sandwich yours. The cashier
throws you a puzzled look. Just then, you come across the sign “We Only Accept Payment in
Euros.” It finally sinks in!
The Sub was selling at a price of €3. Since you only held US Dollars, you rushed to get your
money converted into Euros from the currency exchange. The exchange rate quoted for the day
stood at $1.17 per €1. In simplified terms, a person wishing to convert dollars will have to give
up $1.17 to obtain a unit of Euro. Therefore, the amount in dollars given up to pay for the Sub
equal to (1.17 * 3) $3.51.

Types of Exchange Rates

Fixed Exchange Rate
A fixed exchange rate, also known as the pegged exchange rate, is “pegged” or linked to another
currency or asset (often gold) to derive its value. Such an exchange rate mechanism ensures the
stability of the exchange rates by linking it to a stable currency itself. Also, a fixed currency
system is relatively well protected against the rapid fluctuations in inflation. Some countries
following a fixed rate system include Denmark, Hong Kong, Bahamas & Saudi Arabia.
Advantage
A country with a fixed exchange rate system is attractive to foreign investors who are lured into
investing in that country due to the stability it offers.
Disadvantage
Following such a system, the government of a country has to maintain a huge amount of foreign
exchange or gold reserves to maintain its value. This system thus proves to be an expensive one.
Flexible Exchange Rate
Flexible or Floating exchange rate systems are ones whereby the rate of a currency is determined
by the market forces of demand and supply. Unlike the fixed exchange rate, they do not derive
their value from any underlying. Some economists argue that a floating system is more
preferable since it absorbs the shocks of a global crisis and automatically adjusts to arrive at an
equilibrium.
The country’s central bank may interfere in economically extreme situations such as the
recession or boom to stabilize the currency. They may buy or sell an amount of the currency to
prevent the rates from going haywire. This phenomenon is known as the managed float.
Advantage
A self-sufficient mechanism determines the rates under this system. Therefore, the dependence
on government or international monetary organizations is minimum. Also, the determination of
rate by the market forces of demand and supply promotes efficiency and robustness of
operations.
Disadvantage
Floating rate systems are prone to greater volatility since the market forces determine them. The
increased volatility increases the risk quotient in such markets, consequently making it a
relatively expensive place for foreign investors.
Forward Rate
A forward rate is one that is determined as per the terms of a forward contract. It stipulates the
purchase or sale of a foreign currency at a predetermined rate at some date in the future. A
forward contract is generally entered into by exporters and importers who are exposed to Forex
fluctuations. The forward rate is quoted at a premium or discount to the spot price. This rate is
known as forward premium or discount.
Advantage
A forward contract freezes the rate of exchange for both parties and thus eliminates the element
of uncertainty. Therefore, it provides a complete hedge against all unruly movements in the
market.
Disadvantage
Any exchange does not back a forward contract. Therefore the possibility of default is quite high.
Also, freezing the rates may prove to be a loss-making decision in some situations. For example,
a long forward in a bearish market or a short forward in a bullish market are instances of the
forward backfiring.
Spot Rate
The spot rate is the current exchange rate for any currency. It is the rate at which your currency
shall be converted if you decide to execute a foreign transaction “right now.” They represent the
day-to-day exchange rate and vary by a few basis points every day.
Advantage
Trading at a spot rate does not require deep mathematical or statistical analysis. It is what it is. It
is a straightforward rate without any ambiguity.
Disadvantage
Spot rates can be a misleading indicator in times of economic crisis, unreasonable demand or
supply patterns, or temporary transitional phases in an economy.
Dual Exchange Rate
In this type of system, the currency rate is maintained separately by two values-one rates
applicable for the foreign transactions and another for the domestic transactions. Such systems
are normally adopted by countries that are transitioning from one system to another. This ensures
a smooth changeover without causing much disruption to the economy.
Advantage
Countries enforcing a dual exchange rate can enforce separate rates for capital and current
account transactions. Therefore a significant amount of control is with the government whereby
it can influence revenues from capital or current sources depending upon the need of the hour. It
also becomes easier to regulate international trade and, at the same time, protect the domestic
markets.
Disadvantage
A dual exchange rate system may cause a mis-fixing of the exchange rate and consequent
misallocation of resources in various industries. Because of these, several economic anomalies
such as black markets, arbitrage opportunities, and inflation may emerge.
Also, read Real vs. Nominal Exchange Rate
Interpreting Currency Exchange Quotes
Direct & Indirect Quotes
A direct currency quote uses the domestic or home currency as the base. For example, for an
American national, the direct currency quote to obtain Euros will look like USD/EUR 1.17.
An indirect currency quote denotes the domestic currency as the quoted currency. Or, in simpler
terms, the value of our home currency is expressed in terms of the foreign currency sought to be
acquired or sold. For example, EUR/USD 0.87. This means that a European Currency holder will
have to give up 0.87 Euros to acquire 1 USD.
Bid & Ask Price
In practical life, currency quotes are always quoted as USD/EUR 1.1681-1.1685
The former part of the quote, USD/EUR 1.1681, is known as the bid rate. Bid Rate is the rate at
which the bank will pay you should you go to it to buy Euros against USD. It is nothing but
the buying rate for the bank.
The latter part of the quote, USD/EUR 1.1685, is known as the ask rate. Ask Rate is the rate
which the bank “asks” from you to obtain a unit of Euro against the value in the dollar. It is
nothing but the selling rate for the bank.
It is important to know that the ask rate will always exceed the bid rate. The bank will always
buy at a lower rate and sell at a higher rate. The simple reason is that the difference is the margin
that the bank earns for facilitating such currency exchange.
Cross Currency Rate
Reserve currency or an anchor currency is essentially the one in terms of which most other
currencies are expressed. Such currency is held in large amounts by governments as Forex
reserves. The US Dollar is currently the most widely held reserve currency, followed by the
Euro.
Consequently, a currency quote not expressed in terms of USD is known as a cross rate. All
dominant and frequently traded currencies are translated in terms of USD. However, certain
transactions may be such that they do not contain the dollar component at all. In such cases, the
currency quotes are required to be expressed at a rate relative to one another to facilitate that
exchange.
The following example shall clear the concept.
A manufacturer in Germany wants to obtain certain automobile parts from a supplier in
Australia. The supplier only accepts payment in Australian Dollars (AUD). Therefore, the
German manufacturer will be compulsorily required to convert EUR to AUD to close the
contract. The amount payable to the Australian Supplier is AUD 350,000.
The following quotes are quoted by the exchange.
EUR/USD 1.1670-1.1674
USD/AUD 1.3561-1.3570
The quote relevant to the German manufacturer is EUR/AUD
Therefore, the same is obtained by carrying out the simple work mentioned below

The simple multiplication of (bid*bid)-(ask*ask) gives the required cross rate.

= (1.1670*1.3561) -(1.1674-1.3570)
=1.5826-1.5841
Therefore, the amount payable to the bank to obtain AUD 350,000 is (350,000/1.5841) EUR
220,945.