Foreign Exchange Market Concepts

Imagine you spent the day at a currency exchange office. You walked in with EUR 10,000 and decided to exchange it for US dollars. Then you handed it back to them to exchange it back to euros. Then back to US dollars.

If you did this all day, how much money do you think you'd have when you left the office at the end of the day?

Absolutely. The people sitting there all day exchanging currencies aren't going to just hand you free money. They're there to _make_ money. So every time you make an exchange, you'd lose a little.

No, you wouldn't actually. Consider that the currency exchange workers are there to make money.

No. The currency exchange workers aren't going to let you do that.

So when you see a pair of exchange rates of 1.1130 and 1.1104, meaning that it takes USD 1.1130 to make one euro, or it takes USD 1.1104 to make one euro, what you know for sure is that you will get the worse rate. The difference is how the office makes money. So if you are handing them euros, they will give you USD 1.1104 for each euro. If you are giving them US dollars, they will take USD 1.1130 for each euro they give you. In other words, they are offering you euros at an __offer rate__ of USD 1.1130, and they are bidding for your euros at a __bid rate__ of USD 1.1104. Considering how this should then work for any currency pair, what general rule could you state about these two rates?

Not quite. That's only because of this pairing. If the discussion were about the cost of US dollars in euros, then the rates would be around 0.9.

Yes! Again, currency traders need to make money. So in any currency pair, they will offer to let you pay more for a currency than they will bid to purchase it. That inequality has to hold. This difference is the __bid–offer spread__ (or the __bid–ask spread__; same thing).

No, this is not a valid connection. Think about what rates are possible for other currency pairs, and what currency traders would bid and offer.

There are multiple ways of quoting currencies, which can, unfortunately, lead to confusion. The most logical way is to think of a __base currency__ quoted in terms of a __price currency__. Just like measuring speed in km/h means you're calculating the kilometers traveled in one hour, and selling bananas at USD 0.45/lb. means that you pay USD 0.45 per pound, an exchange rate may be quoted as 1.2105 USD/GBP. How would you interpret this?

No, just the opposite. This can be confusing, but again, think about other rates like km/h or USD/lb.

Exactly!

The rate USD/GBP means the number of US dollars (the price) to purchase one British pound (the base).

There are several factors that influence the size of the bid–ask spread. Say a dealer buys and sells on the large interbank market and then turns around to buy and sell to clients. Keeping in mind that, like the currency exchange workers mentioned before, everyone needs to make money for their work, how do you expect the bid–ask spread in the interbank market compares to that of a dealer working with clients?

Precisely. Dealers have to eat. There are a lot of factors that determine a spread. If the currency pair is traded often in the interbank market, there will be high liquidity and a lower spread. The dealer will then competitively offer a low spread to clients (although still higher than that of the interbank market). So the spread depends in part on the popularity of the currency pair. If the size of the transaction is large, then of course the dealer can afford to offer a lower spread. Smaller transactions, higher spread.

Actually, no. This would cause the dealer to lose money on each transaction. Consider that the dealer has to turn around and transact in the interbank market.

Not so. If this were the case, the dealer would be volunteering time and effort.

The spread can even change depending on the time of day. Think again about liquidity affecting the spread. What times do you think would lead to the lowest spread?

Well, no. That's not the case in most places, and consider that the "last hour of the day" is relative to a given location.

No. Less competition would indicate reduced liquidity, and therefore larger spreads.

Exactly. This happens in the mid-morning hours in New York, which is the end of the day in London. Those are the two biggest centers for the foreign exchange market. When they are both open, liquidity generally reaches a peak. Dealers will offer different spreads to different clients as well, and they will certainly want to consider a higher spread when markets are volatile. If the price is changing a lot, they might need that extra cushion to ensure a profitable day.

To summarize: [[summary]]

EUR 10,000

Less than EUR 10,000

More than EUR 10,000

The offer rate is always larger than 1.0

The offer rate is always larger than the bid rate

The offer rate is higher than the bid rate only if the quoted rates are larger than 1

It takes about GBP 1.21 to make USD 1.00

It takes about USD 1.21 to make GBP 1.00

The interbank spread is lower than what the dealer quotes

The interbank spread is higher than what the dealer quotes

The interbank spread is the same as what the dealer quotes

During the last hour of the day

During the night when there is less competition

During times when more trading centers are open

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