A Beginner's Guide to Exchange Rates and the Foreign Exchange Market  
[Part 1: Exchange Rates  What are they and how are they calculated?] by Mike Moffatt 

Like most other rates in economics, the exchange rate is essentially a price and can be analyzed in the same way we would a price. Take a typical supermarket price, say lemons are selling at the price of 3 for a dollar or 33 cents each. Then we can think of the dollartolemon exchange rate as being 3 lemons because if we give up one dollar, we can get three lemons in return. Similarly, the lemontodollar exchange rate is 1/3 of a dollar or 33 cents, because if you sell a lemon, you will get 33 cents in return. So when we speak of an XtoY exchange rate of Z, this means that if we give up 1 unit of X, we get Z units of Y in return. If we want to know the YtoX exchange rate, we calculate it using the simple exchange rate formula:YtoX exchange rate = 1 / XtoY exchange rate Of course, the exchange rates we read in the paper or hear on radio or TV are not prices for X and Y or for oranges and lemons. Instead they're relative prices for different currencies, but they work in the same fashion. On February 26, 2003 the U.S.toJapan exchange rate was 117 yen, so this means that you can purchase 117 Japanese yen in exchange for 1 U.S. dollar. To figure out how many U.S. dollars you can get for 1 Japanese yen, we can just use the formula: JapantoU.S. exchange rate = 1 / U.S.toJapan exchange rate JapantoU.S. exchange rate = 1 / 117 = .00854 So this tells us that one Japanese yen is worth .00854 U.S. dollars, which is less than a penny. Similarly if the Canadian dollar is worth .67 U.S. dollars, we have a CanadatoU.S exchange rate of .67. If we want to know how many Canadian dollars we can buy with 1 U.S. dollar, we use the formula: U.S.toCanada exchange rate = 1/CanadatoU.S. Exchange rate U.S.toCanada exchange rate = 1/0.67 = 1.4925 So one U.S. dollar can get us $1.49 in Canadian funds. To see why these relationships must hold, we'll look at the wonderful world of arbitrage. Next page > Part 2: Exchange Rates  Arbitrage > Page 1, 2, 3, 4, 5, 6, 7, 8. 