Wednesday, September 30, 2009

Foreign exchange

In finance, the exchange rate between two currencies specifies how much one currency is worth in terms of the other. For example an exchange rate of 120 Japanese Yen to the Dollar means that ¥120 is worth the same as $1. An exchange rate is also known as a foreign exchange rate, or FX rate.

An exchange rate quotation is given by stating the number of units of a price currency can be bought in terms of a unit currency. For example, in a quotation that says the Euro-United States Dollar exchange rate is 1.2 dollars per euro, the price currency is the dollar and the unit currency is the euro. The usual unit currency varies by geographic location. For example, British newspapers quote exchange rates with British pounds as the unit currency. This is known as indirect or quality terms quotation and is also common in Australia and New Zealand.

Quotes using a country's home currency as the unit currency are known as direct or appreciating (i.e. if the currency is becoming more valuable) then the exchange rate number increases. Conversely if the price currency is strengthening, the exchange rate number decreases and the unit currency is depreciating.

In practice it is rarely possible to exchange currency at the exact rate quoted. Market makers who match together buyers and sellers will take a commission. This is achieved by quoting a bid/offer spread. For example if you are bidding to buy Japanese yen you would do so at the bid price of say, ¥115 per dollar, and if you were offering to sell yen you might do so at ¥125 yen per dollar.

If a currency is free-floating its exchange rate against other countries can vary against other such currencies. In fact such exchange rates are likely to be changing almost constantly as quoted by financial markets and banks around the world. If the value of the currency is "pegged" its value is maintained by the government in question at a fixed rate relative to the other currency. For example, in 2003 the Hong Kong dollar was pegged to the United States dollar.

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