While quoting the rates for a currency, the practice is to keep the number of units of one currency fixed, while varying that of another. The currency whose units remain fixed is the base currency, while the other whose units keep changing is the variable currency. In the above quote, the US dollar is obviously the base currency, while the rupee is the variable currency.
Every currency has a three-letter code assigned to it by the International Standards Organization (ISO). The code for the dollar is USD while that for the rupee is INR. Thus, the exchange rate would be represented as 54.2500 USD-INR. That is, the code for the base currency is given first, followed by the variable currency. The two codes are separated by a hyphen or a back slash.
In practice, there are two possibilities. We can treat the domestic currency as the variable currency and the foreign currency as the base currency or the other way around. Consequently, there are two quoting conventions known as direct quotes and indirect quotes. A quote in which the domestic currency is the variable currency is referred to as direct. Thus, a quote of 52.8500 USD-INR, as given by a bank in Mumbai, is a direct quote.
On the other hand, a quote where the domestic currency is the base currency is referred to as indirect. For instance, a quote of 112.50 USD-JPY, if given by a bank in New York City, would be classified as an indirect quote, where JPY is obviously the code for the Japanese yen.
The reason why we can have two valid quoting systems is the following. Take a commodity such as a bottle of mineral water. The normal practice is to quote a price, say, R20 per bottle. That is, the unit of the good is kept fixed, while that of the currency is variable. If we wish, we could quote the price as 0.05 bottles per rupee, although we would not do so in practice. The difference in the case of foreign exchange quotes is that we are dealing with two currencies. Thus, a quote in terms of rupees per dollar is as valid as a quote in terms of dollars per rupee. In India, till August 1993, we were following the indirect system and, subsequently, we have switched to the direct method.
The phrases, European terms and American terms, are also used in the market. A quote where the US dollar is the base currency is a quote as per the European convention, while a quote where it is the variable currency is a quote as per the American convention. Thus, a direct quote for the dollar in India would be a quote as per the European convention, while a direct quote for the Japanese yen in New York would be a quote as per the American convention.
A foreign exchange dealer would give two prices for a currency, one being the rate at which he is willing to acquire the foreign currency from the client, and the other representing the rate at which he is willing to sell it to a prospective client. The first is termed as the bid and the second as the ask or offer.
Let us take the case of direct quotes first. The quote at a point in time in the Mumbai market may be 53.2500-54.6000 USD-INR. That is, the dealer will payout R53.25 while acquiring a dollar, but will charge R54.60 while selling a dollar. When acquiring a foreign currency, he would like to pay as little as he can in terms of Indian currency, while when he is selling a foreign currency, he would like to charge as much as possible in terms of the rupee.
Thus, the bid will be lower than the ask rate, and the maxim is buy low and sell high. However, in the case of an indirect quote, the dealer would like to acquire as many units of the foreign currency as possible while buying, whereas he would like to part with as few units of the foreign currency while selling. Thus, we may observe a quote in New York such as 123.25-122.30 USD-JPY. This implies that the dealer will pay out one dollar for every 123.25 yen acquired while buying, but will charge one dollar for every 122.30 yen sold while selling. The principle is buy high and sell low.
This counter-intuitive result may be understood as follows. In a direct quote, the bid is the rate for buying the base currency and the ask rate is the rate for selling the base currency. In an indirect quote, however, the bid is the rate for buying the variable currency, while the ask rate is the rate for selling the variable currency. The words purchase and sale in the case of foreign exchange quotes are always used from the dealers perspective. In a purchase transaction, the dealer will acquire the foreign currency from the client and pay out the domestic currency, while in a sale transaction, he will pay out the foreign currency to a client in return for the domestic currency.
The writer is the author of Fundamentals of Financial Instruments published by Wiley, India