As a cooperative professor of International Financial Management, I find many of my students initially confused by the indirect and direct quotes of foreign exchange. It does not help that most textbooks introduce this very practical concept in theoretical examples that contribute to the bewilderment, and others get the formulas incorrect.
The idea itself is pretty straightforward.
Let’s assume you’re a Chinese citizen looking to travel abroad. You currently have 100RMB sitting in your wallet that you plan to change into a foreign currency during your travels. The important thing to know now is how to understand the exchange rates – the rate at which one currency is traded for another.
Exchange Rates can be written in two different ways because there are at least two currencies involved in the trade. You can either write the exchange rate of Currency A or Currency B.
Let’s assume that you will be traveling from China to the United States with a layover in South Korea. That brings three separate currencies into play:
- Chinese Renminbi, aka Chinese Yuan (RMB or CNY)
- Korean Won (KRW)
- American Dollar (USD)
The exchange rates will tell you how much Korean Won or American Dollars you can buy with your 100RMB. Or conversely (coming home) how much RMB you can buy with the leftover Korean Won or American Dollars.
Exchange Rate Example:
You arrive on your plane in South Korea. Just through the airplane gates, you stop by the local ATM. You have 100RMB but you want to trade it for some Korean Won so you can pick up some souvenirs. The ATM lets you know that the current exchange rate is:
1KRW = 0.0058RMB
This means that if you put into the ATM 0.058RMB, you’ll be given 1 Korean Won (barring fees). Or conversely, if you put in 1KRW, they will give you 0.0058RMB.
We mentioned before that an exchange rate can be written in two different ways. One tells you the exchange rate for 1KRW (helpful for local Koreans). The other flips the rate using the reciprocal to identify the exchange rate for 1RMB (helpful for you with 100RMB to calculate).
|Person holding 100 Korean Won|
= 0.0058RMB x 100
|Person holding 100 Chinese RMB|
= 172.41KRW x 100
We would thus be able to say that the value of 1KRW is 0.0058RMB and simultaneously the value of 1RMB = 172.41KRW. Both rates stem from the same equation; which is more useful depends on the user of the rate.
Accounting and Finance defined these two methods of writing the exchange rate as either a Direct Quote or an Indirect Quote.
The Direct Quote
The Direct Quote (also known as the American Terms) is used to show the value of 1 unit of a foreign currency in the local denomination. For the Chinese citizen, this means showing the value of 1 Korean Won in local RMB. The exchange rate written as a Direct Quote for our Chinese traveler would be:
1KRW = 0.0058RMB
This will be helpful for our traveler in interpreting Korean prices while he travels or in translating the Korean money has left over into RMB when he comes home.
Suppose our global friend visits the National Museum of Korea and is interested in purchasing a beautiful vase from the gift shop. The price listed on the vase is 2,000,000KRW. But he is using his Chinese bank card and wants to know how much RMB will leave his bank account in the transaction.
The Indirect Quote
The Indirect Quote (also known as the European Terms) is used to show the value of 1 unit of the domestic currency in the foreign denomination. For the Chinese citizen, this means showing the value of 1 RMB in terms of Korean Won. The exchange rate written as an Indirect Quote for our Chinese traveler would be:
1RMB = 172.41KRW
This will be helpful for our traveler in translating domestic amounts into how much they would be worth in a foreign currency. For example, deciding how much your current bank account would be worth if you used it to travel abroad or how much is available to invest in foreign companies.
Suppose our tourist heads to South Korea with 500,000RMB in his savings account set aside for hotels and meals. How much would he be able to spend in Korea while he is there?
The Korean Perspective
It is important to remember that Koreans would see the situation differently because they are looking at the exchange rate from the opposite point of view.
Korea’s Direct Quote:
(Foreign Currency / Domestic Currency)
Korea’s Indirect Quote:
Domestic Currency / Foreign Currency