Exchange Rate Definition
Exchange rate — also called the foreign exchange rate or forex rate — is the price one country’s currency can be exchanged for another country’s currency. Simply, it tells you how much your money (i.e. your domestic currency) is worth in another country’s currency (i.e. foreign currency). An exchange rate is a type of conversion rate, or the rates at which any commodity, currency, or security can be exchanged for another.
An exchange rate has two parts: the domestic currency and the foreign currency for which it is being exchanged. Exchange rates can be quoted either directly or indirectly, and are defined as follows:
- Direct quotation: The price of the foreign currency is valued in terms of the domestic currency. For example: US $1 = JPY 113.88, where the U.S. dollar is the base currency and the Japanese Yen is foreign currency. In lay terms, if you have $1 U.S. dollar, you will receive 113.88 Japanese Yen.
- Indirect quotation: The price of the domestic currency is valued in terms of the foreign currency. For example: JPY 100 = US $0.88, where the Japanese Yen is the base currency and the U.S. dollar is the foreign currency. In lay terms, if you have 100 Japanese Yen, you will receive $0.88 U.S. dollars.
It’s important to note that most exchange rates use the U.S. Dollar as the base currency. A few exceptions to this would be be Euro, British Pound, or Australian Dollar.
Every country decides what type of exchange rate regime they will apply to their currency. The types of exchange rates include:
- Free-floating or flexible: Exchange rates are allowed to vary against other currencies and is determined by market forces like supply and demand. Exchange rates for free-floating or flexible currencies are quoted by banks on global financial markets.
- Fixed: A currency’s exchange rates is fixed to against another currency, either from one country or a grouping of countries; it can also be fixed to another measure of value, such as gold. Some fixed exchange rates will have a provision for revaluation as needed.
- Pegged exchange rate: A hybrid of fixed and floating exchange rate systems; the exchange rate is “pegged” or fixed to one country or grouping of countries currency, but is allowed to fluctuate within a certain range of around the initial target.
In finance, exchange rates are determined in the foreign exchange market, which is open to various buyers and sellers from banks, foreign exchange brokerages, and various bureaux de change. Trading is continuous, 24 hours a day except weekends. Most exchange rates are flexible exchange rates and can fluctuate minute-by-minute based on what foreign exchange traders (forex traders) think the currency is worth. Factors that influence exchange rates include interest rates, inflation rate, trade balance, political stability, general state of economy, and/or state of governance.
It is not uncommon for businesses or organizations enter into financial transactions with international companies. In such a case, it is important to understand exchange rates — or foreign currency exchange rates — in relation to accounting practices and mitigating losses. A few best practices include, but are not limited to:
- Record the exchange rate in effect on that day. If a business is scheduled to receive a payment from a customer in a foreign currency or will make a payment in a foreign currency to a supplier, record it in the functional currency of the transaction based on the exchange rate on that date.
- Record any loss or gains as a result of changes in exchange rate. A series of gains and/or losses over accounting periods can result in sometimes significant discrepancies in your accounts payable and accounts receivable.
- Adopt understandable accounting policies that are universally accepted by domestic and international business partners.
- Implement adequate internal accounting controls to analyze and detect misstatements in exchange rate transactions.
- Centralize foreign exchange management, if possible. Typically outsourced to a bank that specializes in foreign exchange netting, using a third-party and/or centralized management team can help hedge gains and losses as a result of exchange rate changes.
Source: Exchange Rate Regimes (Wikimedia) ￼