Top International TradersThere is a market convention that determines which is the base currency and which is the term currency. In most parts of the world, the order is:EUR - GBP - AUD - NZD - USD - *** (where *** is any other currency).Thus if you are doing a conversion from EUR into AUD, EUR is the base currency, AUD is the term currency and the exchange rate tells you how many Australian dollars you would pay or receive for 1 euro. Cyprus and Malta which were quoted as the base to the USD and *** were recently removed from this list when they joined the euro. In some areas of Europe and in the non-professional market in the UK, EUR and GBP are reversed so that GBP is quoted as the base currency to the euro. In order to determine which is the base currency where both currencies are not listed (i.e. both are ***), market convention is to use the base currency which gives an exchange rate greater than 1.000. This avoids rounding issues and exchange rates being quoted to more than 4 decimal places. There are some exceptions to this rule e.g.
the Japanese often quote their currency as the base to other currencies.Quotes using a country's home currency as the price currency (e.g., EUR 1.00 = $1.58 in the US) are known as direct quotation or price quotation (from that country's perspective) and are used by most countries.Quotes using a country's home currency as the unit currency (e.g., $0.97 AUD = $1.00 US) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and the eurozone.direct quotation:
1 foreign currency unit = x home currency unitsindirect quotation: 1 home currency unit = x foreign currency unitsNote 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 EURUSD, the first component (EUR in this case) will be called the base currency. The second is called the term currency. For example : EURUSD = 1.5877, means EUR is the base and USD the term, so 1 EUR = 1.5877 USD.Currency pairs are often incorrectly quoted with a "/" (forward slash). In fact if the slash is inserted, the order of the currencies should be reversed. This gives the exchange rate. e.g. if EUR1 is worth USD1.59, euro is the base currency and dollar is the term currency so the exchange rate is stated EURUSD or USD/EUR.
To get the exchange rate divide the USD amount by the euro amount e.g. 1.59/1.00 = 1.59Market convention from the early 1980s to 2006 was that most currency pairs were quoted to 4 decimal places for spot transactions and up to 6 decimal places for forward outrights or swaps. (The fourth decimal place is usually referred to as a "pip.") An exception to this was exchange rates with a value of less than 1.000 which were usually quoted to 5 or 6 decimal places. Although there is no fixed rule, exchange rates with a value greater than around 20 were usually quoted to 3 decimal places and currencies with a value greater than 80 were quoted to 2 decimal places. Currencies over 5000 were usually quoted with no decimal places (e.g. the former Turkish Lira). e.g. (GBPOMR : 0.765432 - EURUSD : 1.5877 - GBPBEF : 58.234 - EURJPY : 165.29). In other words, quotes are given with 5 digits. Where rates are below 1, quotes frequently include 5 decimal places.In 2006 Barclays Capital broke with convention by offering spot exchange rates with 5 or 6 decimal places.
The contraction of spreads (the difference between the bid and offer rates) arguably necessitated finer pricing and gave the banks the ability to try and win transaction on multibank trading platforms where all banks may otherwise have been quoting the same price. A number of other banks have now followed this. Free or peggedMain article: Exchange rate regime 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 (RMB) was pegged to the United States dollar at RMB 8.2768 to $1.
China was not the only country to do this; from the end of World War II until 1966, Western European countries all maintained fixed exchange rates with the US dollar based on the Bretton Woods system. Nominal and real exchange ratesThe nominal exchange rate e is the price in domestic currency of one unit of a foreign currency.The real exchange rate (RER) is defined as , where P is the domestic price level and P * the foreign price level. P and P * must have the same arbitrary value in some chosen base year. Hence in the base year, RER = e.The RER is only a theoretical ideal. In practice, there are many foreign currencies and price level values to take into consideration. Correspondingly, the model calculations become increasingly more complex. Furthermore, the model is based on purchasing power parity(PPP), which implies a constant RER. The empirical determination of a constant RER value could never be realised, due to limitations on data collection.
PPP would imply that the RER is the rate at which an organization can trade goods and services of one economy (e.g. country) for those of another. For example, if the price of a good increases 10% in the UK, and the Japanese currency simultaneously appreciates 10% against the UK currency, then the price of the good remains constant for someone in Japan. The people in the UK, however, would still have to deal with the 10% increase in domestic prices. It is also worth mentioning that government-enacted tariffs can affect the actual rate of exchange, helping to reduce price pressures. PPP appears to hold only in the long term (3–5 years) when prices eventually correct towards parity.More recent approaches in modelling the RER employ a set of macroeconomic variables, such as relative productivity and the real interest rate differential. Bilateral vs effective exchange rateBilateral exchange rate involves a currency pair, while effective exchange rate is weighted average of a basket of foreign currencies, and it can be viewed as an overall measure of the country's external competitiveness.
A nominal effective exchange rate (NEER) is weighted with trade weights. a real effective exchange rate (REER) adjust NEER by appropriate foreign price level and deflates by the home country price level. Compared to NEER, a GDP weighted effective exchange rate might be more appropriate considering the global investment phenomenon.
