The Forex market, Exchange Rate & Bid Ask Spreads

The term Forex is short for Foreign Exchange. The Forex market is most widely traded market in the world. The figure most often cited as the trading volume for the Forex market is $5.1 trillion US dollars daily. If you wish to read more about where this figure came from read:  Triennial Central Bank Survey of foreign exchange and OTC derivatives markets in 2016.

One thing that I will note here is that this figure is often quoted on broker’s website and information material however this does not draw a distinction between the retail Forex market and the institutional Forex market.

The Forex market is quite different from other markets you might be familiar with. The Forex market is known as an interbank market or an Over The Counter (OTC) market. There is no centralised exchange were trading takes place like in the securities market.

In the Forex OTC market there are hundreds of entities usually banks offering to buy and sell different currencies at given rates. These banks tend to offer the currencies at very similar prices due to the arbitrage effect.

Getting back to the meaning of Forex we can think of Forex as simply the exchanging of one currency for another. The need for Forex arises when individuals from one country wish to purchase goods or services from a foreign currency. This is best illustrated by way of example:

I wish to travel to America and visit New York’s financial district. In order for me to pay for goods and services I need to exchange my Australian Dollars for American dollars. I take my Australian dollars down to my bank and on a large screen I read the exchange rate information.

I now hand over $AUD 3,000 and the teller consults the rate above and she would for every Australian dollar I give her give me back $USD 0.8158 which off course is $USD 2, 447.4.

The above example highlights what is known as an Exchange rate. An exchange rate is most commonly defined as the price of one currency in terms of another. Exchange rates are usually quoted in two different ways an indirect quote and a direct quote.

Indirect quote
A quote that expresses a currency price in terms of one unit of the home currency and x units of the foreign currency. In short it just means that the home currency is the base currency or first currency expressed in terms of the foreign currency. If we live in Australia an example of an indirect quote would be AUD/USD 0.8168. Generally the banking system of England and countries formally of England quote on an indirect basis.

Direct Quote
A quote that expresses a currency price in terms of one unit of the foreign currency and x units of the home currency. If we live in Australia we can convert the indirect quote AUD/USD 0.8168, into a direct quote of approx USD/AUD 1.2243. This is achieved by dividing one by the indirect quote and adding one.

Another important thing you need to know is about exchange rates is the base currency or the commodity currency. The base or commodity currency is the currency whose price is given in the exchange rate. The base currency is always the first currency quoted and is always one.

The next things we need to know about foreign currency transactions are bid and ask prices. You may have noticed in the above picture that the AUD/USD has a bid price and an ask price.

The bid price is the price the bank is willing to buy the currency for. If you wanted to sell one Australian dollar to the bank they would buy it to from you for $USD 0.8158. This is known as the bid price.

The ask price is the price the bank is willing to sell the currency for. If you wanted to buy one Australian dollars from the bank you would need to give them $USD 0.8168. This is known as the ask price.

Why is the Ask price always more then the Bid price?
The difference between the ask price and the bid price is known as the bid ask spread. This is simple when you think about it the bank will always sell the currency for a higher price than it pays for it. In the above example the bank would make $USD 0.0010 for every buy/sell transaction they undertake.

This article should allow you to understand the key financial terms and also shed some light on what Forex actually means. It is very important that you thoroughly understand difference between bid and ask prices as they can be very easily confused. It might be confusing at first as time goes on it will become easier.

No Responses

Leave a Reply