Understanding corporate finance: foreign exchange: what is an exchange rate?
What is an exchange rate?
An exchange rate is simply the price of a unit of currency used in one country or area expressed in the money of another country or area. The idea of an exchange rate is familiar to anyone who has been on holiday abroad. A British tourist who travels to the US will need to know how many US dollars they will get for each pound. An exchange rate can be expressed by one of the following three methods.
From the point of view of someone living in the UK, the price of each unit of foreign currency could be expressed in terms of the home currency, sterling. So, using the exchange rates at 15 April 2002, we could express the US dollar and euro exchange rates respectively as:
£0.6960 = $1, or £0.6960/$ and
£0.6335 = €1, or £0.6335/€
As a corollary to a direct quotation, we could express the value of each pound sterling in terms of the dollar, or the euro:
$1.4368 = £1, or $1.4368/£ and
€1.6335 = £1, or €1.6335/£
Cross exchange rate
A cross exchange rate is the value of one foreign currency expressed in another. For example, we can deduce from the above figures that if $1.4368 and €1.6332 are both worth £1, then:
- €1 must be worth $0.8796 (1.4368/1.6335)
- $1 must be worth €1.1369 (1.6335/1.4368)