FREE online courses on Investment Decisions in Exchange Rates - Method of Quotation

 

The are two methods of quotation for exchange rates between the dollar and the currency of another country.  The two methods are referred to as the direct (American) and indirect (European) methods of quotation.  The exchange rate between any two non-dollar currencies is referred to as a cross rate:

 

Direct-American Quotation

 

The dollar price of one unit of foreign currency.  For example, a direct quotation of the exchange rate between dollar and the British pound (German mark) is $1.6000/£1 ($0.6000/DM1), indicating that the dollar cost of one British pound (German mark) is $1.6000 ($0.6000).  Direct exchange rate quotations are most frequently used by banks in dealing with their non-bank customers.  In addition, the prices of currency futures contracts traded on the Chicago Mercantile Exchange are quoted using the direct method.

 

Indirect-European Quotation

 

The number of units of a foreign currency that are required to purchase one dollar.  For example, an indirect quotation of the exchange rate between the dollar and the Japanese yen (German mark) is ¥125.00/$1 (DM 1.6667/$1), indicating that one dollar can be purchased for either 125.00 Japanese Yen or 1.6667 German Marks.

 

Cross Rates

 

The exchange rate between any two non-dollar currencies is referred to as a cross rate.  A relatively large number of cross rates would be required to trade every currency directly against every other currency.  For example, N currencies would require N x (N-1)/2 separate cross rates.  For this reason, most exchange rates are quoted in terms of dollars and by far the greatest volume of trading directly involves the dollar.  This reduces the number of cross-currency quotes that dealers must keep track of and reduces the potential losses associated with mispricing currencies relative to one another (which permits Triangular Arbitrage).