In the frenzied world of currency trading where daily trading volumes exceed $5 trillion, tight trading spreads are the norm for deals between banks in the interbank market, with only a few pips separating a currency's bid and ask prices. Exchange rates quoted by banks to their large corporate, institutional and government clients are also very competitive and have narrow spreads.
However, the retail markets tell an entirely different story. The spread between the bid and ask price for a currency in the retail market is usually quite large, and may also vary significantly from one forex dealer to the next. Since this difference in rates can have quite an impact on your wallet, it is always in your interest to shop around for the best exchange rate. First, let’s delve into the world of forex to get a basic understanding of how exchange rates are calculated and interpreted.
The Forex Bid-Ask Spread
The bid-ask spread is simply the difference between the price at which a dealer will buy and sell a currency. In other words, the bid price is what the dealer is willing to pay or “bid” for a currency, while the “ask” price is how much the dealer wants for a currency.
Consider an American traveler – let’s call her Ellen – who is visiting Europe. She is confronted by the following price for euros at an airport exchange kiosk:
EUR 1 = USD 1.30 / USD 1.40
The higher price (i.e., USD 1.40) is what the dealer is asking per euro. Since Ellen wants to buy EUR 5,000, she would have to pay the dealer $7,000.
What if the next traveler in line – Katelyn – has just finished her European vacation and before boarding her flight back to the U.S., wants to sell the euros she has left over. By sheer coincidence, Katelyn has EUR 5,000 to sell. She would sell the euros to the kiosk dealer at the bid price of USD 1.30, and would receive $6,500 for her euros.
The difference of $500 ($7,000 - $6,500) arising from these two transactions represents the kiosk dealer’s profit, and arises from the bid-ask spread that we defined above.
Direct and Indirect Currency Quotes in Forex Markets
We now come to the topic of direct and indirect currency quotations. 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 reciprocal of a direct quote, and expresses the amount of foreign currency per unit of domestic currency.
Since the US dollar is the dominant currency in forex markets, most currencies are quoted in direct quote form (i.e., USD/JPY and USD/CAD), which refers to the amount of Japanese yen and Canadian dollars per one U.S. dollar, respectively. (Note: 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 (i.e., GBP/USD and EUR/USD, which refers to the amount of US dollars per one British pound and euro, respectively).
For instance, consider the Canadian dollar, which is quoted in the forex market at 1.0750 (let’s ignore the bid-ask spread for now). This quotation would take the form USD 1 = CAD 1.0750. In Canada, 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 or 93.02 US cents.
Next, consider the British pound as an example of an indirect quote. GBP 1 = USD 1.7000 represents an indirect quote in Great Britain, 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 or 58.82 pence.
Forex Currency Rates and Cross Currencies
An understanding of how currencies are quoted is crucial when dealing with cross-currency rates, which refers to the price of one currency in terms of a currency other than the U.S. dollar, a situation often encountered by travelers.
Let’s say you are a Canadian resident who is traveling to Europe and needs euros. The spot 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 (i.e., 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 were to sell one euro.
The calculation would be a little different if both currencies were quoted in direct form. Continuing with the above example, let’s assume the approximate spot rate for the Japanese yen is USD 1 = JPY 102, and you wish to calculate the price of yen in Canadian dollars.
Since USD 1 = CAD 1.0750 and USD 1 = JPY 102, it follows that CAD 1.0750 = JPY 102, or CAD 1 = JPY 94.88 (i.e., 102 / 1.0750).
Forex Points to Remember
- In most countries, forex dealers will display exchange rates in direct form (or the amount of domestic currency required to buy one unit of a foreign currency). This makes intuitive sense since we are used to seeing prices for goods and services in our domestic currency.
- Here’s the basic rule when it comes to exchanging a currency: When faced with a standard bid-ask quote 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.
- When dealing with cross currencies, establish whether the currencies involved are generally quoted in direct form (e.g., Canadian dollar, Japanese yen, Swiss franc, Mexican peso, Chinese yuan, Indian rupee) or indirect form (e.g., euro, British pound, Australian dollar, New Zealand dollar). If both currencies are quoted in direct form, the approximate cross-currency rate would be Currency A divided 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.
Tips for Forex Currency Conversion
- Shop around for the best rates. Forex rates can vary between dealers and moneychangers in the same city. A few minutes online to compare exchange rates can be well worth the time spent if it saves you 0.5% or 1%.
- Forego airport currency kiosks. It’s no secret that airport kiosks have the worst exchange rates, with extremely wide bid-ask spreads. Receiving 5% less of the currency you are buying is a pretty stiff price to pay for the convenience of changing money at the airport. 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.
- Do not hesitate to ask for a better rate. Some dealers will automatically improve the posted rate for larger amounts, but others may not do so unless you specifically request a rate improvement. So don’t hesitate to ask.
- Have an approximate idea of spot exchange rates. If you haven’t had the time to shop around for the best rates, at least have an idea of the spot exchange rate to understand the cost of 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, but you can mitigate the impact of these spreads on your wallet by shopping around for the best rates, foregoing airport currency kiosks and asking for better rates for larger amounts.