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 the bid and ask prices for a currency. Exchange rates quoted by banks to their large corporate, institutional and government clients are also very competitive, with narrow spreads. But it is an entirely different story as far as retail clients are concerned. 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. But first, let’s delve into the world of forex to get a basic understanding of how exchange rates are calculated and how you can interpret them.The bid-ask spread
The bid-ask spread is simply the difference between the price at which a dealer will buy a currency and the price at which the dealer will sell a currency. In other words, the bid price is the price that the dealer is willing to pay or “bid” for a currency, while the “ask” price is the price that the dealer wants for a currency.
Consider an American traveler – let’s call her Ellen – who is visiting Europe and 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 the price that 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 – Clark – has just finished his European vacation and before boarding his flight back to the U.S., wants to sell the euros he has left over. By sheer coincidence, Clark has EUR 5,000 to sell. He would sell the euros to the kiosk dealer at the bid price of USD 1.30, and would receive $6,500 for his euros.
The difference of $500 (i.e. $7,000 – $6,500) arising from these two transactions represents the kiosk dealer’s profit, and arises from the bid-ask spread.
Direct and indirect currency quotes
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, as for example USD/JPY and USD/CAD, which refers to the amount of Japanese yen and Canadian dollars per one US dollar respectively. (Note that 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, as for example GBP/USD and EUR/USD, which refers to the amount of US dollars per one British pound and euro respectively.
A couple of examples may clarify the above points. 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.
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 US dollar, a situation often encountered by travelers.
Let’s say you are a Canadian resident who is traveling to Europe and therefore need some euros. The spot exchange rates in the forex market are approximately USD 1 = CAD 1.0750, and EUR 1 = USD 1.3400. Thus, it follows that the approximate EUR/CAD spot rate would be EUR 1 = CAD 1.4405 (i.e. 1.3400 x 1.0750). So 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).
Points to remember
source;http://www.investopedia.com/articles/forex/090914/understanding-spread-retail-currency-exchange-rates.asp
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