Series 3: 3.1.1. Foreign Exchange (FX) And Exchange Rates

3.1.1. Foreign Exchange (FX) and Exchange Rates

Any currency that is used in settling international transactions other than the local currency is called foreign exchange. The rate at which two currencies are exchanged is called the exchange rate. Suppose, for example, that $1 dollar today exchanges for the euro at €0.75. If the dollar rises, or strengthens, relative to the euro, $1 will be able to buy more euros, say €0.95. If it can buy more euros, it can buy more European goods. A falling dollar, or weakening dollar, will see a drop in the exchange rate and a drop in its purchasing power in other countries.

Foreign exchange may be measured in two ways. First, it may be measured in American terms as U.S. dollar per foreign currency ($ / currency). In spot market trading, the euro, the British pound, and the Australian dollar are each quoted in American terms. When the exchange rate gets larger, the dollar gets weaker and the foreign currency appreciates, or gets stronger. This is because a larger exchange rate means more dollars are needed to purchase one unit of the foreign currency. The price of the currency has gone up.

Most other currencies are quoted in European terms as foreign currency per U.S. dollar (currency / $). Here, the foreign currency depreciates, or gets weaker, as the exchange rate increases and the dollar appreciates. In either case, when the exchange rate increases, the base currency, the currency in the denominator, gets stronger. The currency in the numerator is called the term currency.