Foreign currency exchange rates show the value of one currency through a comparison to another currency, expressed in currency pairs.
In order to make sense of exchange rates for currency pairs, this short guide to understanding foreign currency exchange rates will explain the basic terminology and dynamics forex traders should understand to know when trading currencies.
Currency values can only be expressed relative to one another, which is why their value is expressed in pairs. In any currency pair, the first currency listed is the “base currency,” followed by the “quote currency” or “variable currency,” which tells the reader how much of the quote currency is required to buy a unit of the base currency. To put it another way, the price of one unit of the first currency listed is expressed in units of the second currency.
Currency pairs are always fluctuating, due to the near-constant activity on foreign exchange markets around the world. These changes can be the results of a number of factors, but the most important influences are market dynamics driven by news of economic indicators in various countries and the resulting trading and commercial activity. In many cases, these price movements are only small factions of the value of a currency, known as “pips” by forex traders.
The International Organization for Standardization (ISO) is an independent, non-governmental organization that develops consensus-based international standards in many industries, including technology, manufacturing and finance. They have established the standards for international currency naming conventions, under ISO 4217:2015, that specify the three-letter alphabetic codes to represent currencies.
The currency codes used in foreign exchange markets, such as USD (American dollar), EUR (Euro), and CAD (Canadian dollar), all stem from their longstanding efforts.
Direct & Indirect Quotes
Given the American dollar’s status as the most popular global reserve currency, most other currencies are quoted directly against USD.
When a quote is “direct” it refers to the amount of foreign currency required to buy one USD. In other words, direct quotes display the price of a unit of foreign currency in units of the domestic currency. Although direct quotes involving USD are the norm, quotes can be expressed in terms of any two currencies.
In an indirect quote, the domestic currency is used as the base currency, with the foreign currency as the quote currency. To put it differently, indirect quotes show the price of a domestic currency in terms of units of a foreign currency.
Converting Foreign Currency Exchange Rates - Example
An example using a popular currency pair, USD/CAD, will be helpful to show how to calculate exchange rates in practice.
If you see a direct quote for USD/CAD listed at 1.22, it will cost you $1.22CAD to buy $1USD.
If you want to flip the conversion around and find out how much CAD you can get for one USD, all you need is a simple division. Use the rate (in this example, 1.22) as the divisor, where 1 is the dividend, so 1 / 1.22 = 0.8196.
This means that it would cost you about $0.82 USD to buy $1 CAD.
If you want to exchange currency at a local bank, you won’t get the same exchange rate as forex traders because banks “charge” for their trading services through price markups.
To return to the previous example, if USD/CAD is on the market at 1.22 then the bank might offer it at something closer to 1.26. Although this might seem marginal at a glance, with the daily volume of trading on forex markets in the trillions, these markups add up quickly.
Another way of putting it is that the bid-ask spread reflects the difference between the buying and selling price that a broker offers for a currency. So, if you wanted to sell foreign currency, you would be quoted the bid price. If you want to buy, you would be quoted the ask price.
Say you come across a bid-ask price for the British pound of $1.3790/1.3850, buying pounds would mean that you pay the ask price of $1.3850.
If you had a change of heart and immediately sold them back, the broker would purchase them at $1.3790. So, you would lose $0.006 per unit as a result of the bid-ask spread.
Make Currency Exchange Rates Work For You
As you can see, the stakeholders in forex markets, such as banks and currency exchanges, find ways of generating profits through exchange rate conversions. And you can too. If you need to buy or sell currencies and want to better understand the risks involved in order to capitalize on opportunities, contact Olympia Trust.
With over 20 years of experience delivering customized solutions to complex foreign currency conversion problems, Olympia Trust can help you mitigate your risk and boost your bottom line.