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Foreign Exchange Quotations
Currency prices are determined by a number of factors, the most important of which are economic and political conditions in the issuing country. Political stability, inflation, and interest rates are all factored into the price of any currency. In addition, governments can try to control the price of their currency by either flooding the market (to lower the price) or buying extensively (to raise the price).
Because of the immense volume of foreign exchange (Forex), however, it is impossible for one force to control the market for any length of time. Market forces will prevail in the long run, making foreign exchange one of the most open and fair investment opportunities available.
Each world currency is given a three letter code which is used in foreign exchange quotations. The most common currencies are USD (US dollars), EUR (European euros), GBP (United Kingdom pounds), AUD (Australian dollars), JPY (Japanese yen), CHF (Swiss francs) and CAD (Canadian dollars).
A foreign exchange quotation is the actual price or the bid/ask price of either cash commodities or futures or options contracts at a particular time. Foreign exchange quotations are indicative market prices, normally used for information purposes only.
Currencies are quoted in pairs. The first listed currency is known as the base currency, while the second is called the counter or quote currency. In the wholesale market, currencies are quoted using five significant numbers, with the last placeholder called a point or a pip.
Like all financial products, foreign exchange quotations include a "bid" and "ask". When quoting both the bid and ask in real time, traders receive a fair price on all transactions. As in any traded instrument, there is an immediate cost in establishing a position. For example, USD/JPY may bid at 131.40 and ask at 131.45; this five-pip spread defines the trader’s cost, which can be recovered with a favourable currency move in the market.
Reading foreign exchange quotations may seem a bit confusing at first. However, it's really quite simple if you remember two things: 1) The currency listed first is the base currency, and 2) the value of the base currency is always 1.
The US dollar is the centrepiece of the foreign exchange market and is normally considered the 'base' currency for foreign exchange quotations. In the "Majors", this includes USD/JPY, USD/CHF and USD/CAD. For these currencies and many others, foreign exchange quotations are expressed as a unit of $1 USD per the second currency quoted in the pair. For example, a foreign exchange quotation of USD/JPY 120.01 means that one U.S. dollar is equal to 120.01 Japanese yen.
When the U.S. dollar is the base unit and the foreign exchange quotation goes up, it means the dollar has appreciated in value and the other currency has weakened. If the USD/JPY foreign exchange quotation we previously mentioned increases to 123.01, the dollar is stronger because it will now buy more yen than before. The exceptions to this rule are those currency that have a higher value in comparison to the US dollar, in which case they are used as the base currency in foreign exchange quotations. The British pound (GBP) and the Euro (EUR) are current examples. In these cases, you might see a foreign exchange quotation such as GBP/USD 1.4366, meaning that one British pound equals 1.4366 U.S. dollars.
In these currency pairs, where the U.S. dollar is not the base rate, a rising foreign exchange quotation means a weakening dollar, as it now takes more U.S. dollars to equal one pound or euro.
In other words, if foreign exchange quotations go higher, that increases the value of the base currency. A lower foreign exchange quotation means the base currency is weakening.
Currency pairs that do not involve the U.S. dollar are called cross currencies, but the premise is the same. For example, a foreign exchange quotation of EUR/JPY 127.95 signifies that one Euro is equal to 127.95 Japanese yen.
When trading foreign exchange you will often see two-sided foreign exchange quotations, consisting of a 'bid' and 'offer'. The 'bid' is the price at which you can sell the base currency (at the same time buying the counter currency). The 'ask' is the price at which you can buy the base currency (at the same time selling the counter currency). For example a foreign exchange quotation of USD/CAD 1.1121/24 specifies a bid price of 1.1121 CAD for each US$ 1 and a respective buy price of 1.1124.
Direct And Indirect Foreign Exchange Quotations On the Currency exchange market in every country, the local currency is quoted directly or indirectly against the American dollar and the other foreign currencies. The direct foreign exchange quotation is the amount of the local currency that is needed to buy one unit of the foreign currency and respectively the amount of local currency that is due to be received when one unit of foreign currency is being sold. In Japan, for example:
120.44 – 120.52 USD/JPY signifies that the dealers are buying one dollar for 120.44 yen, but are selling the very same unit for 120.52 yen.
Alternatively the indirect foreign exchange quotation is the amount of the foreign currency needed to buy one unit of the local currency, the amount of foreign currency that is received if one local currency unit is sold to a dealer. This type of indirect foreign exchange quotation is used for British pounds versus the US dollar, for example:
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Bid Price, Ask Price (Spread) Like all traded instruments (stocks, bonds, futures etc.) there is a selling price (known as the “bid” price) and a buying price (the “ask” price). The difference between the two is called the “spread”. The Spread is comprised of the cost a trader incurs when taking a position.
Consider the following foreign exchange quotations: GBP/USD 1.6545/1.6550 Sell Price/Buy Price
If you decide to long the currency pair (buy the base currency) because you think it will appreciate in value, you would enter the trade at the buy price, which means that if you wanted to immediately turn around and sell the same currency you just bought, you would have to sell it at the sell price, which is always lower than the buy price and you would lose the difference of that spread. In other words, the price of the currency you just bought would have to appreciate the value of the spread for you to break even.
The same thing applies if you want to sell the base currency, only you would enter the trade at the sell price which means that if you wanted to buy back what you just sold before the exchange rate had a chance to move, it would cost you the spread (in this case, 5 pips).
When you open a trade, the trading platform will show you the price you bought or sold the currency pair at. If, for example, you go long (buy) a currency pair, it will show the price you bought at, as well as the current sell price (the buy price minus the spread). In order to get into profit, the market will have to move at least the number of pips in the spread for you to break even. What this obviously means is that the tighter the spread, the better, because it means that the currency has a smaller value to rise before you’re into profit.
Standard Spreads The good news is that, because we have the advantage of dealing directly with the market makers, most spreads in the currency market tend to be very tight (much tighter than any other financial market), not to mention, we also avoid round-turn commissions that traders in other markets pay to the brokerage houses on each and every trade.
The standard spread can vary from currency pair to currency pair. The more heavily a currency pair is traded, the less volatile it tends to be. Therefore, the most heavily traded currency pairs (the majors) tend to have the tightest spreads, whereas, the less traded, more volatile currency pairs (the crosses & exotics) tend to have wider spreads. The standard spread is 4-5 pips on the Majors and 5-20 pips on the Crosses & Exotics.
The closer the two prices are to each other, the “tighter” the spread, and the further they are from each other, the “wider” the spread.
In all cases, the bid (sell) price is always lower then the ask (buy) price.
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Copyright 2006. © Foreign Exchange Quotations |
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