An exchange rate is the price of one currency expressed in terms of another currency — specifically, how many units of a foreign currency are needed to buy one unit of the domestic currency.

How it is quoted:

• Direct quote (home currency per unit of foreign currency): e.g., £1 = $1.25 — how much foreign currency you get per unit of domestic currency
• Indirect quote (foreign currency per unit of home currency): e.g., $1.25 = £1 — more common in financial markets

Exchange rates work as a price mechanism:

• If a currency’s exchange rate rises (it becomes more expensive), imports become cheaper and exports become more expensive
• If a currency’s exchange rate falls (it becomes cheaper), imports become more expensive and exports become cheaper

Exchange rates are determined differently depending on the system — either by market forces (floating), by government or central bank policy (fixed), or by a combination of both (managed).