How Foreign Exchange Rates Are Quoted
A forex rate is the rate of exchange of a particular currency relative to another currency. For example, you have a US dollar and would want to exchange it for Japanese Yen. If the forex rate is $1:¥100, you’ll get ¥100 for your USD. Foreign exchange rates are decided by the forex market, a place where currencies are traded 24/5. The forward exchange rate is the current quoted rate but will be delivered and paid in a particular date in the future, while the spot exchange rate is the present exchange rate.
Forex dealers often quote a different rate for buying and selling, especially when you’re trading in the retail forex market. The buying rate is the rate at which forex dealers will purchase the foreign currency, while the selling rate is the rate at which forex dealers will sell the foreign currency. The quoted rate, on the other hand, already includes the dealers profit in trading. In most cases, there are various rates for electronic currency like credit card purchases; documentary currency like traveler’s checks; and cash. Documentary transactions often have a higher rate because the traveler’s checks have to be cleared and costs are also incurred during the clearing process.
Foreign Exchange Rates In The Retail Forex Market
Ordinary people need to trade their local currencies when they want to travel outside of their own country. They buy the foreign currency from a bank or from a domestic money changer. In the foreign country, they can also buy the local currency at the airport, at the hotel, or at a local forex changer. Tourists can also use their credit cards if they want to purchase goods and services. If they have excess foreign currencies, they can sell them before they go home. In all these transactions, foreign exchange rates play a major part.
How Forex Quotations Are Generated
In a foreign currency pair, the quoted price is based on the value of one currency relative to the other in the forex market. Therefore, the foreign exchange rate of 1.25 of EUR/USD means that 1 Euro is equivalent to USD 1.25. The EUR is the base currency while the USD is the term currency. There is a hierarchy when it comes to foreign currencies. The EUR or euro is on top of the hierarchy and followed by the GBP or sterling pound; AUD or Australian dollars; NZD or New Zealand dollars; USD or USD dollars; and the others.
If the currencies aren’t listed, the market convention is to make the currency with an exchange rate of at least 1.00 as the base currency in order to prevent rounding problems. This convention also prevents foreign exchange rates as being quoted to at least 4 decimal places. However, the Japanese Yen is an exception to this because it is often quoted as a base currency. A direct quotation is a foreign exchange rate which has the nation’s local currency as the price currency. On the other hand, an indirect quotation is a quote which has the nation’s local currency as the unit currency.
In a direct quotation, if the local currency strengthens, the foreign exchange rate number is decreased. On the other hand, if the foreign currency strengthens, the foreign exchange rate number is increased and the local currency is said to be depreciating.
From the 1980s up to 2006, the market convention is to quote foreign currency pairs up to 4 decimal places for spot exchange transactions. For swaps or forward outrights, the currency pairs are quoted up to 6 decimal places. However, Barclays Capital disregarded the market convention in 2005 by quoting spot foreign exchange rates from 5 to 6 decimal places in order to allow contraction of spreads.