Foreign Exchange Rate In finance, the foreign exchange rates or exchange rates or FX ratesbetween two currencies specify how

much one currency is worth in terms of other. For example an exchange rate of 50indian rupees to US Dollar means that INR 50 is worth same as USd 1. Quotations An exchange rate quotation is given by stating the number of units of term currency that can be bought in terms of 1 unit currency known as base currency. For example, in a quotation that says the USD/INR exchange rate is 50 i.e 50 Rs for each US dollar,the term currency is INR and the base currency is USD

Direct Vs Indirect quotation

A Direct quote is a quote where the exchange rate is expressed in terms of number of units of domestic currency per unit of foreign currency Example: Rs/$ : 48.62/48.72 Here the bank would be buying dollars @ 48.60/$ and selling dollars @ 48.72/$. An indirect quote is where the exchange rate is expressed in terms of number of units of the foreign currency for a fixed number of units of domestic currency. Example: $/100 Rs : 2.0525/67 Here the bank would be buying dollars @$2.0567/Rs100 and selling dollars @ 2.0525/Rs100. Before August 2, 1993, the indirect methods of quoting exchange rates used to be followed in India. Since that date, however, the direct quotes are used.

American Vs. European quote

A quote can be classified as European or American only if one of the currencies is the dollar. An American quote is the number of dollars expressed per unit of some other currency, while a European quote is the number of units of any other currency per dollar For example, Rs48.28/$ is a European quote, while $1.6698/GBP is an American quote. In almost all the countries exchange rates are expressed as European quotes. The British Pound , the south African Rand are few examples of currencies expressed in American quotes.

Bid and Ask Rate

In rupee Dollar exchange market , banks act as a market makers. This means that bank is ready to both buy and sale the currency at some rate. Therefore, the rate at which bank is ready to buy dollar will be different from the rate at which it stands ready to sell that currency. This rates are called bid and ask rates respectively. Example: Rs/$ : 48.60/48.72 Here the bank is ready to but dollars @ 48.60 and at the same time ready to sell dollars @48.72 The difference in these rates represents the cost the bank incurs in the transactions, and a small return on the capital employed, and the compensation for the risk it takes. . The difference between the bid rate and ask rate is called the bid ask spread, or simply the spread. The spread is seen higher in retail market then in interbank market There is counterparty risk, lower liquidity and high risk of transaction being set off at a disadvantageous rate in the retail market and therefore higher spread.

Interbank Quote Vs. Merchant Quote Merchant quote is given by a bank to its retail customers. On the other hand, a quote given by one bank to another or any other player in interbank market is called interbank quote. According to FEDAI rules, exchange rates in the merchant as well as interbank markets are to be quoted up to 4 decimals, with last two digits being in multiples of 25(for example: Rs/ $:48.6250/75). The card rates of banks should be either quoted in two decimals, or quoted in 4 decimals with last two digits being 0.

Exchange Rate System

There are different ways in which the exchange rate can be determined. Exchange rates may be free Floating or with limited flexibility.

Fixed Vs Floating Exchange rate system

Under the fixed exchange rate system the value of one currency in terms of another is fixed. These rates are determined by the governments or central banks of the respective countries. The fixed exchange rates results from countries pegging their currencies to either some common commodity or some particular currency There is generally some provision of some correction of these fixed rates in case of a fundamental disequilibirium Examples of this system are Gold standard and the Bretton Woods system Under floating rate system, the exchange rate between the currencies is variable. These rates are determined by the demand and supply of the currencies in international market. Exchange rates depend on the flow of money between the countries, which may either result due to trade in goods and service, or due to purely financial flows In case of deficit or surplus in the BOP, difference in interest rates , inflation rates etc automatically gets adjusted The exchange rate is said to be freely floating when its movements are totally determined by the market. There is no intervention at all either by the government or by central banks. This system is also known as clean float. The volatility of exchange rates associated with the clean float increases economic uncertainity faced by players in the international markets. In order to reduce these inefficiencies, central bank generally intervene in the currency markets to smoothen the fluctuations. Such system is referred to as a managed float or dirty float. In India managed float is practiced where RBI from time to time intervene the currency market to stabilize it by buying or selling dollar Nominal and Real exchange rates The nominal exchange rate is the price in domestic currency of the unit of a foreign currency. The real exchange rate (RER) is defined as RER=e(p*/p), where p* is the domestic price level and p is the foreign price level. It measures the countrys competitiveness in international trade. The RER is only a theoretical concept. In practice, there are many foreign currencies and price level values that are to be considered. Correspondingly, the model calculations become increasingly more complex.

More recent approaches in modeling the RER employ a set of microeconomic variables, such as relative productivity and the real interest rate differential NR=(RR+1)(Expected inflation+1)-1 Bilateral Vs Effective exchange rate Bilateral exchange rate involves a currency pair, while effective exchange rate is weighted average basket of foreign currencies, it can be viewed as an overall measure of countrys external competitiveness. A nominal effective exchange rate(NEER)is weighted with trade weights. A real effective exchange rate (REER) adjusts NEER by appropriate foreign price level and deflates by the home country price level. Compared to NEER, a GDP weighted effective exchange rate might be more appropriate considering the global investment phenomenon.