Understanding Forex Rates

Forex rates are a complex issue to deal with for beginners. While understanding where, how and why forex rates are moving in a particular direction is important, first we need to understand what these rates mean. In a series of articles dedicated to forex rates, I will try and answer some basic questions regarding forex market and what moves them. Here is first such article covering the very basics of forex.

What is forex?
Forex or still shorter FX is an acronym for foreign exchange refers to the exchange rate of currencies of two countries. Immediately a question comes to our mind as to what is exchange rate. Exchange rate is the rate at which one currency can be converted into another currency. Say, if I have Rs 100 and I am travelling to USA, then I would need the money in Dollars. Thus I need to convert Rs 100 that I have to dollars. How much dollars would I get with those Rupees is known as the exchange rate.

How is it quoted?
Forex rates are quoted with for two currencies at a time. Say, in the above example it would be Dollars and Rupees. International Organization for Standards has fixed up currency codes for all the currencies and rates are quoted with the help of these codes. For USA’s dollar code is USD and for Indian rupee, the code is INR. So exchange rate of India and USA will be quoted as USDINR. Similarly other exchange rates are quoted as EURUSD (Euro and Dollar) or GBPUSD (British Pound and Dollar) and so on. Quotes like this are also known as currency pairs.

What does foreign exchange quote mean? How do we interpret currency pair?
Currency pair typically indicates how much of one currency is need to buy 1 unit of other currency. Thus rates are quoted in terms of one of the currencies for the other one.

Here I will introduce two terms: base currency and quote currency

Base currency: Indicates the currency for which the rates are quoted. It is the currency mentioned first in the currency pair.

Quote currency (terms currency): Currency in terms of which the quote is given. It is the currency mentioned second in the pair.

What does USDINR indicate then?
USD or US Dollars is the base currency and INR or Indian Rupee is the quote currency and a quote of USDINR=45.59 indicates that Rs 45.59 is required to buy 1 Dollar or conversely, if you have 1 Dollar, you can get Rs 45.59 by selling it. Importance of base currency lies in the fact that we always think buying and selling with respect to base currency.

What does a bid/ask indicate in currency pair?
Like any other trading value, currencies are quoted in terms of bid and ask. A typical currency pair is quoted as USDINR-45.6000/45.6025 (Bid/Ask). As indicated in the above question, we always think buying and selling for base currency. Thus 45.6000 indicates buyer’s price for USD and 45.6025 indicates seller’s price for USD.

What are cross rates?
When rates are determined for a pair with the help of two other pairs, the determined rate is known as cross rates. For instance, if 1 apple costs to Rs 10, and 1 banana costs you Rs 5, the 1 apple can be exchanged for 2 bananas. This rate of 2 bananas for 1 apple is known as cross rates. Similarly, if 1 usd costs you Rs 45.60 and 1 Euro costs to 1.5 USD (i.e EURUSD-1.5), then you can get 1 Euro for Rs 68.4 (i.e 45.60*1.6).

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In future articles we will discuss about other aspects of currency markets.

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