by Michael Totten

Created on: January 27, 2009   Last Updated: January 30, 2009

The exchange rate between two currencies is the value of one currency against the value of the other. It will usually be cited in one of two ways. Where two and only two currencies are commonly interchanged, as with the United States dollar and the Canadian dollar, it is most common to state the relative values as an equation: for example, 1 USD = 1.20 CAD. The currency which is set as equivalent to 1 is called the base currency, while the other is called the term currency. The financial rule is that base currencies follow the order EUR (euro), GBP (British pound), AUD (Australian dollar), NZD (New Zealand dollar), USD (United States dollar), and then everything else. However, this rule is often inverted in Great Britain and the United States, which prefer to set their own currencies as alway equal to 1. Because this inverts the roles of the term currency and the base currency, an exchange rate quoted in this way is called an indirect quotation.

Where a larger number of currencies are referenced or in the context of forex speculation, the exchange rate is more commonly expressed as a ratio: for example, EUR:USD at 1.5. Such quotations will always follow the financial rule of base currencies. An exchange rate quoted in this way is called a direct quotation.

An official exchange rate will usually be perfectly equivalent in both directions, although there can be exceptions where the exchange rate is set or closely managed by a central bank. A current official exchange rate is also known as a spot rate. This is in contrast to a forward exchange rate, which is the forex market's equivalent of a futures quote. Forward exchange rates are also commonly used by international businesses for future pricing, invoicing, and contracts.

A spot exchange rate is usually quoted to two, three, or four decimal places, although Barclay's Capital quotes its spot exchange rates to up to six decimal places. The lower the value of the term currency relative to the base currency, the fewer decimal places will be used, while the closer the value of the term currency relative to the base currency, the more decimal places will be used.

Economists sometimes use the distinction between nominal exchange rates and real exchange rates. The nominal exchange rate is simply the cost of a currency, expressed against the value of the local currency. Thus it will usually be an indirect quotation. In contrast, the real exchange rate is considered to be the ratio between the prices of equivalent products.

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