An exchange rate is the price of a nation’s currency in terms of another currency. Thus, an exchange rate has two components, the domestic currency and a foreign currency, and can be quoted either directly or indirectly.
For example, an interbank exchange rate of 112 Japanese yen to the United States dollar means that ¥112 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥112.
Why do exchange rates change?
Exchange rates fluctuate due to one major factor: global demand and supply. The more in-demand a particular currency is, the more its value will increase.
Factors that affect demand and supply of currency include governments and businesses trading internationally, countries’ political and economic stability, travel and tourism, trading of currencies on the stock market and even natural disasters.
Exchange rates are also influenced by countries’ rules and actions that govern their currency, known as their fiscal policy.
Interest rates play a large role in exchange rate fluctuation. Favourable interest rate movements will drive demand for a particular currency – driving up its value.
Breaking down the 'Exchange Rate'
An exchange rate has a base currency and a counter currency.
In a direct quotation, the foreign currency is the base currency and the domestic currency is the counter currency.
In an indirect quotation, the domestic currency is the base currency and the foreign currency is the counter currency.
Most exchange rates use the US dollar as the base currency and other currencies as the counter currency.
However, there are a few exceptions to this rule, such as the euro and Commonwealth currencies like the British pound, Australian dollar and New Zealand dollar.
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