Fundamentals of Business

Direct quotation: 1 foreign currency unit = x home currency units

Indirect quotation: 1 home currency unit = x foreign currency units Note that, using direct quotation, if the home currency is strengthening (i.e., appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating.

When looking at a currency pair such as EUR/USD, many times the first component (EUR in this case) will be called the base currency currency.

The second is called the counter currency currency. For example: EUR/USD = 1.2836, means EUR is the base and USD the counter, so 1 EUR = 1.2836 USD.

Free or pegged

If a currency is free floating, its exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand. Exchange rates for such currencies are likely to change almost constantly as quoted on financial markets, mainly by banks, around the world. A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the devaluation of a currency.

For example, between 1994 and 2005, the Chinese Yuan renminbi (CNY ¥) was pegged to the United States dollar at ¥8.2768 to $1. The Chinese were not the only country to do this; from the end of World War II until 1970, Western European countries all maintained fixed exchange rates with the US dollar based on the Bretton Woods system.

Nominal and real exchange rates

The nominal exchange rate
is the rate at which an organisation can trade the currency of one country for the currency of another.

The real exchange rate (RER) is an important concept in economics, though it is quite difficult to grasp concretely. It is defined by the model: RER = e (P*/P), where 'e' is the exchange rate, as the number of home currency units per foreign currency unit; where P is the price level of the home country; and where P* is the foreign price level.