Foreign exchange, or forex, is the exchange of one currency for another at an agreed-upon price. The price at which one currency is exchanged for another is known as the forex rate. This exchange rate is constantly fluctuating based on market demand and supply. As a forex trader or investor, it is essential to understand how to calculate the forex rate. In this article, we will discuss different methods of calculating the forex rate.
Method 1: Direct Quotation
Direct quotation is the most commonly used method to calculate the forex rate. In this method, the forex rate is quoted in terms of the local currency. For instance, if you are in the United States and want to find out the forex rate of the euro, the direct quotation will quote the euro in terms of the US dollar. In this case, the forex rate will be the number of US dollars required to purchase one euro.
Let’s take an example to understand this better. If the forex rate of EUR/USD is 1.1300, it means that one euro can be purchased for 1.1300 US dollars. Similarly, if you want to find out the forex rate of the Japanese yen in terms of the US dollar, the direct quotation will quote the yen in terms of the US dollar. For example, if the forex rate of USD/JPY is 110.50, it means that one US dollar can be exchanged for 110.50 Japanese yen.
Method 2: Indirect Quotation
In indirect quotation, the forex rate is quoted in terms of the foreign currency. It is the opposite of direct quotation. In this method, the forex rate is quoted as the number of foreign currency units required to purchase one unit of the local currency. For instance, if you are in the United States and want to find out the forex rate of the euro using indirect quotation, the forex rate will be quoted as the number of euros required to purchase one US dollar.
For example, if the forex rate of USD/EUR is 0.8800, it means that one euro can be purchased for 0.8800 US dollars. Similarly, if you want to find out the forex rate of the US dollar in terms of the Japanese yen, the indirect quotation will quote the US dollar in terms of the Japanese yen. For example, if the forex rate of JPY/USD is 0.0090, it means that one US dollar can be exchanged for 0.0090 Japanese yen.
Method 3: Cross Rates
Cross rates are used to calculate the forex rate between two currencies that are not the base currency in a particular currency pair. For instance, if you want to find out the forex rate of the euro in terms of the Japanese yen, but the euro and the Japanese yen are not the base currencies in the USD/EUR or USD/JPY currency pairs, you can use cross rates to calculate the forex rate.
To calculate cross rates, you need to use the forex rates of the two currency pairs that involve the currency you want to find the forex rate for. For example, if you want to find out the forex rate of the euro in terms of the Japanese yen, you can use the forex rate of EUR/USD and USD/JPY to calculate the cross rate. To do this, divide the forex rate of EUR/USD by the forex rate of USD/JPY.
For instance, if the forex rate of EUR/USD is 1.1300 and the forex rate of USD/JPY is 110.50, the cross rate of EUR/JPY would be calculated as follows:
EUR/USD = 1.1300
USD/JPY = 110.50
EUR/JPY = EUR/USD ÷ USD/JPY
EUR/JPY = 1.1300 ÷ 110.50
EUR/JPY = 0.0102
Therefore, the forex rate of EUR/JPY is 0.0102 or 1 euro can be exchanged for 0.0102 Japanese yen.
In conclusion, understanding how to calculate the forex rate is essential for forex traders and investors. The three methods discussed in this article – direct quotation, indirect quotation, and cross rates – can be used to calculate the forex rate between different currencies. By knowing how to calculate the forex rate, traders can make informed decisions about when to buy or sell certain currencies and maximize their profits.
