Foreign Exchange Quoting Conventions
Merchants and traders have been exchanging currencies for thousands of years. Today foreign exchange (FX) markets are some of the largest OTC markets in the world.
If you want to buy something —whether it is a cup of coffee, an ounce of gold, or a stock— you need to know how much a unit of that item is going to cost. The price per unit can be quoted in any currency. A cup of coffee might cost 5 euros, an ounce of gold might cost 2,000 USD (US dollars), and the price of a stock might be quoted as 234 JPY (Japanese yen). Similarly, if you wish to acquire a certain amount of a foreign currency, you need to know how much that currency is going to cost. For example, you might be told that 100 JPY will cost 1 USD, or
100 JPY = 1 USD
Rather than writing it this way, most FX market participants would write the exchange rate as
USDJPY = 100
This combination of two currencies, in this case USDJPY, is known as a currency pair. The first currency, in this case USD, is often referred to as the over or base currency. The second currency, in this case JPY, is often referred to as the under, counter, or quote currency. For both currencies, we are using the standard three letter ISO currency code. All widely used currencies have a standard three letter ISO code.
The second currency is referred to as the quote currency because this is the currency in which the price is being quoted. USDJPY = 100 means that 1 unit of USD cost 100 JPY.
If, instead of USDJPY, we wrote JPYUSD, then USD would be the quote currency. If 1 USD costs 100 JPY, then 1 JPY should cost 0.01 USD. We would then write
JPYUSD = 0.01
Technically we are free to quote both USDJPY and JPYUSD, but markets participants have a preference for a particular order. This is largely a matter of historical convention. In the case of USD and JPY, most market participants will quote USDJPY, not JPYUSD. For this pair, this has the advantage of achieving the same precision with fewer decimal places. Many currencies are quoted in this way, so that the quoted level is greater than one, but this is not always the case. The convention is based on the rank or order of the currency. For some of the most widely traded currencies, the order is
EUR (European Union euro)
GBP (Great British pound)
AUD (Australian dollar)
USD (United States dollar)
CAD (Canadian dollar)
CHF (Swiss Franc)
JPY (Japanese Yen)
The higher ranked currency will be the first currency in the pair, so we quote EURUSD, not USDEUR, because EUR is ranked higher than USD. Similarly, we quote USDCAD because USD is ranked higher than CAD.
Quoting FX Instruments
Even though currencies pairs have a preferred order for quoting FX rates, financial instruments may be quoted in any order. For example, currency futures on the Chicago Mercantile Exchange (CME) are all quoted per USD. For FX forwards, accounting systems will often base the order of the currency pair on which currency is being delivered and which received.
For FX instruments, if you change the order of the currency pair, then you must also change the quantity. For example, if you want to exchange 100 million JPY for 1 million USD, you have two possibilities. The first option is to specify how much USD you are going to buy, and to quote the price of this USD in JPY. If you do that, then you would have
Quantity = 1 million
Price = 100
You are exchanging 1 million USD, and the price of each unit of USD is 100 JPY, which is equivalent to quoting 100 USDJPY.
You could also choose the opposite convention
Quantity = 100 million
Price = 0.01
In this case, you are exchanging 100 million JPY, and the price of each unit of JPY is 0.01 USD, which is equivalent to 0.01 JPYUSD.