An exchange rate is simply the ratio of one currency valued against
another. The first currency is referred to as the base currency and the
second as the counter or quote currency. If buying, an exchange rate
specifies how much you have to pay in the counter or quote currency to obtain
one unit of the base currency. If selling, the exchange rate specifies how much
you get in the counter or quote currency when selling one unit of the base currency.
A currency exchange rate is typically given as a bid price and an ask price.
The bid price is always lower than the ask price. The bid price represents
what will be obtained in the quote currency when selling one unit of the base
currency. The ask price represents what has to be paid in the quote currency
to obtain one unit of the base currency. The following USD/JPY price quote is
an example of bid/ask notation:
The first component (before the slash) refers to the bid price (what you obtain
in JPY when you sell USD). In this example, the bid price is 118.48. The second
component (after the slash) is used to obtain the ask price (what you have to
pay in JPY if you buy USD). In this example, the ask price is 118.58.
The difference between the bid and the ask price is referred to as the spread.
In the example above, the spread is .10 or 10 pips. Unlike the USD/JPY, most
currency pair quotes are carried out to the 4th decimal place (i.e. EUR/USD
may be quoted at 0.9517/27), in which case 10 pips represents a difference of
.0010. Although a pip may seem small, a movement of one pip in either direction
can translate into thousands of dollars in gains or losses in the inter-bank
market.
When trading amounts of $1M or higher, the spread obtained in a quote is typically
5 to 6 pips. When trading smaller amounts, the spread is typically larger. For example,
when trading less than $100,000, spreads of 50-200 pips are common. Credit card
companies typically apply a spread of 200-300 pips. Banks and exchange bureaus
typically use a spread in the range of 200-1000 pips (in addition to charging
a commission). For investors and speculators, a lower or tighter spread translates
into easier profit taking due to movements in exchange rates.
Buying and Selling
All trades result in the buying of one currency and the selling of another,
simultaneously.
Buying ("going long") the currency pair implies buying the
first, base currency and selling an equivalent amount of the second, quote currency
(to pay for the base currency). It is not necessary to own the quote currency
prior to selling, as it is sold short. A trader buys a currency pair if he/she
believes the base currency will go up relative to the quote currency, or equivalently
that the corresponding exchange rate will go up.
For more detail on the mechanics of a currency trade, please refer to the
Overview
of a Currency Trade document.
