Definition of Exchange Rate : A foreign exchange rate is simply the price of one country's money in terms of another country's money. In other words, the rate at which one country's money or currency buys or exchanges for another country's money or currency is known as the rate of exchange. And foreign exchange is the mechanism by which the currency of one country gets converted into the currency of another country.
Individuals and firms normally do not buy and sell foreign currencies for their own sake but in the process of buying and selling something else - a product, a service or a financial asset. In this sense, foreign exchange transactions are fundamentally a part of the payments mechanism. Again, it connects the price system of' two countries whose currencies are involved in an exchange rate. For example, suppose one rupee exchanges for 3 pence of the English currency. It means in effect, that what one rupee can buy in India, 3 pence can buy in
England. Therefore, by converting a rupee into pence, an Indian can buy 3 pence worth of goods in England, not directly, but indirectly through buying the British currency first and goods and services later.
Now let us see how this conversion takes place. The prospective importer of British goods would approach a bank which is authorised to deal in foreign exchange. The bank would issue a draft payable in British pounds on its branch or its correspondent bank in the U.K in exchange for equivalent value plus its charges. The importer would then send this draft to the exporter who can English it at the bank on which it is drawn. An exporter of Indian goods would similarly approach a bank for selling the foreign currency draft received by him and to, receive the equivalent sum in Indian rupees minus the bank charges. Thus foreign exchange transactions are very conveniently handled by banks.