The bid-ask spread (informally referred to as the buy-sell spread) is the difference between the price a dealer will buy and sell a currency. However, the spread, or the difference, between the bid and ask price for a currency in the retail market can be large, and may also vary significantly from one dealer to the next.
Understanding how exchange rates are calculated is the first step to understanding the impact of wide spreads in the foreign exchange market. In addition, it is always in your best interest to research the best exchange rate.
- The bid-ask spread (or the buy-sell spread) is the difference between the amount a dealer is willing to sell a currency for versus how much they will buy it for.
- Exchange rates vary by dealer, so it's important to research the best rate before exchanging any currency.
Bid-Ask Spreads in the Retail Forex Market
The bid price is what the dealer is willing to pay for a currency, while the ask price is the rate at which a dealer will sell the same currency.
For example, Ellen is an American traveler visiting Europe. The cost of purchasing euros at the airport is as follows:
- EUR 1 = USD 1.30 / USD 1.40
The higher price (USD 1.40) is the cost to buy each euro. Ellen wants to buy EUR 5,000, so she would have to pay the dealer USD 7,000.
Suppose also that the next traveler in line has just returned from her European vacation and wants to sell the euros that she has left over. Katelyn has EUR 5,000 to sell. She can sell the euros at the bid price of USD 1.30 (the lower price) and would receive USD 6,500 in exchange for her euros.
Because of the bid-ask spread, the kiosk dealer is able to make a profit of USD 500 from this transaction (the difference between USD 7,000 and USD 6,500).
When faced with a standard bid and ask price for a currency, the higher price is what you would pay to buy the currency and the lower price is what you would receive if you were to sell the currency.
Direct and Indirect Currency Quotes in Forex Markets
A direct currency quote, also known as a “price quotation,” is one that expresses the price of a unit of foreign currency in terms of the domestic currency. An indirect currency quote, also known as a “volume quotation,” is the opposite of a direct quote. An indirect currency quote expresses the amount of foreign currency per unit of domestic currency.
Most currencies are quoted in direct quote form (for example, USD/JPY, which refers to the amount of Japanese yen per one U.S. dollar). The currency to the left of the slash is called the base currency and the currency to the right of the slash is called, the counter currency, or quoted currency.
Commonwealth currencies such as the British pound and Australian dollar, as well as the euro, are generally quoted in indirect form (for example, GBP/USD and EUR/USD, which refer to the amount of US dollars per one British pound and per one euro).
Consider the Canadian dollar. In Canada, this quotation would take the form of USD 1 = CAD 1.0750. This represents a direct quotation, since it expresses the amount of domestic currency (CAD) per unit of the foreign currency (USD). The indirect form would be the reciprocal of the direct quote, or CAD 1 = USD 0.9302.
Next, consider the British pound. In the United Kingdom, this quotation would take the form of GBP 1= USD 1.700. This represents an indirect quotation since it expresses the amount of foreign currency (USD) per unit of domestic currency (GBP). The direct form of this quote would be USD 1 = GBP 0.5882.
Understanding How Currencies are Quoted
When dealing with currency exchange rates, it's important to have an understanding of how currencies are quoted.
Suppose there is a Canadian resident who is traveling to Europe and needs euros. The exchange rates in the forex market are approximately USD 1 = CAD 1.0750, and EUR 1 = USD 1.3400. That means the approximate EUR/CAD spot rate would be EUR 1 = CAD 1.4405 (1.3400 x 1.0750). A currency dealer in Canada might quote a rate of EUR 1 = CAD 1.4000 / 1.4800, which means that you would pay 1.48 Canadian dollars to buy one euro and would receive 1.40 Canadian dollars if you sold one euro.
The calculation would be different if both currencies were quoted in direct form. If the approximate spot rate for the Japanese yen is USD 1 = JPY 102, this is how you would calculate the price of yen in Canadian dollars:
- USD 1 = CAD 1.0750 and USD 1 = JPY 102
- CAD 1.0750 = JPY 102, or CAD 1 = JPY 94.88 (102 / 1.0750)
In general, dealers in most countries will display exchange rates in direct form, or the amount of domestic currency required to buy one unit of a foreign currency.
How to Calculate Cross-Currency Rates
When dealing with cross currencies, first establish whether the two currencies in the transaction are generally quoted in direct form or indirect form. If both currencies are quoted in direct form, the approximate cross-currency rate would be calculated by dividing "Currency A" by "Currency B."
If one currency is quoted in direct form and the other in indirect form, the approximate cross-currency rate would be "Currency A" multiplied by "Currency B."
When you calculate a currency rate, you can also establish the spread, or the difference between the bid and ask price for a currency. More importantly, you can determine how large the spread is. If you decide to make the transaction, you can shop around for the best rate.
Exchange Rates Vary by Dealer
Rates can vary between dealers in the same city. Spending a few minutes online comparing the various exchange rates can potentially save you 0.5% or 1%.
Airport kiosks have the worst exchange rates, with extremely wide bid-ask spreads. It's possible to receive 5% less of the currency you are buying. It may be preferable to carry a small amount of foreign currency for your immediate needs and exchange bigger amounts at banks or dealers in the city.
Some dealers will automatically improve the posted rate for larger amounts, but others may not do so unless you specifically request a rate improvement. If you haven’t had the time to shop around for the best rates, research ahead of time so you have an idea of the spot exchange rate and understand the spread. If the spread is too wide, consider taking your business to another dealer.
The Bottom Line
Wide spreads are the bane of the retail currency exchange market. However, you can mitigate the impact of these wide spreads by researching the best rates, foregoing airport currency kiosks and asking for better rates for larger amounts.