What are foreign currency exchange rates?

Foreign currency exchange rates are what it costs to exchange one country’s currency for another country’s currency. For example, if you go to England on vacation, you will have to pay for your hotel, meals, admissions fees, souvenirs and other expenses in British pounds. Since your money is all in US dollars, you will have to use (sell) some of your dollars to buy British pounds. Assume you go to your bank before you leave and buy $1,000 worth of British pounds. If you get 565.83 British pounds (£565.83) for your $1,000, each dollar is worth .56583 British pounds. This is the exchange rate for converting dollars to pounds. If £565.83 isn’t enough cash for your trip, you will have to exchange more US dollars for pounds while in England. Assume you buy another $1,000 worth of British pounds from a bank in England and get only £557.02 for your $1,000. The exchange rate for converting dollars to pounds has dropped from .56583 to .55702. This means that US dollars are worth less compared to the British pound than they were before you left on vacation. Assume that you have £100 left when you return home. You go to your bank and use the pounds to buy US dollars. If the bank gives you $179.31, each British pound is worth 1.7931 dollars. This is the exchange rate for converting pounds to dollars. Theoretically, you can convert the exchange rate for buying a currency to the exchange rate for selling a currency, and vice versa, by dividing 1 by the known rate. For example, if the exchange rate for buying British pounds with US dollars is .56011, the exchange rate for buying US dollars with British pounds is 1.78536 (1 ÷ .56011 = 1.78536). Similarly, if the exchange rate for buying US dollars with British pounds is 1.78536, the exchange rate for buying British pounds with US dollars is .56011 (1÷ 1.78536 = .56011). This is how newspapers often report currency exchange rates. As a practical matter, however, you will not be able to buy and sell the currency at the same price, and you will not receive the price quoted in the newspaper. This is because banks and other market participants make money by selling the currency to customers for more than they paid to buy it and by buying the currency from customers for less than they will receive when they sell it. The difference is called a spread and is discussed later in this booklet.

How can I trade foreign currency exchange rates?

As you can see from the example, currency exchange rates fluctuate. As the value of one currency rises or falls relative to another, traders decide to buy or sell currencies to make profits. Retail customers also participate in the Forex market, generally as speculators who are hoping to profit from changes in currency rates. Foreign currency exchange rates may be traded in one of three ways: 1. On an exchange that is regulated by the Commodity Futures Trading Commission (CFTC). For example, the Chicago Mercantile Exchange offers Forex futures and options on futures products. Exchange-traded Forex futures and options provide their users with a liquid, secondary market for contracts with a set unit size, a fixed expiration date and centralized clearing. 2. On an exchange that is regulated by the Securities and Exchange Commission (SEC). For example, the Philadelphia Stock Exchange offers options on currencies (i.e., the right but not the obligation to buy or sell a currency at a specific rate within a specified time). Exchange-traded options on currencies have characteristics similar to exchange-traded futures and options (e.g., a liquid, secondary market with a set size, a fixed expiration date and centralized clearing). 3. In the off-exchange, also called the over-the-counter (OTC), market. A retail customer trades directly with a counterparty and there is no exchange or central clearing house to support the transaction. Off-exchange trading is subject to limited regulatory oversight.

How does the off-exchange currency market work?

The off-exchange Forex market is a large, growing and liquid financial market that operates 24 hours a day. It is not a market in the sense that there is no central trading location or “exchange.” Most of the trading is conducted by telephone or through electronic trading networks.  The primary market for currencies is the “interbank market” where banks, insurance companies, large corporations and other large financial institutions manage the risks associated with fluctuations in currency rates. The true interbank market is only available to institutions that trade in large quantities and have a very high net worth. In recent years, a secondary OTC market has developed that permits retail investors to participate in Forex transactions. While this secondary market does not provide the same prices as the interbank market, it does have many of the same characteristics

How are foreign currencies quoted and priced?

Currencies are designated by three letter symbols. The standard symbols for some of the most commonly traded currencies are:

EUR Euros
USD United States dollar
CAD Canadian dollar
GBP British pound
JPY Japanese yen
AUD Australian dollar
CHF Swiss franc

Forex transactions are quoted in pairs because you are buying one currency while selling another. The first currency is the base currency and the second currency is the quote currency. The price, or rate, that is quoted is the amount of the second currency required to purchase one unit of the first currency. For example, if EUR/USD has an ask price of 1.2170, you can buy one Euro for 1.2170 US dollars. Currency pairs are often quoted as bid-ask spreads. The first part of the quote is the amount of the quote currency you will receive in exchange for one unit of the base currency (the bid price) and the second part of the quote is the amount of the quote currency you must spend for one unit of the base currency (the ask or offer price). In other words, a EUR/USD spread of 1.2178/1.2170 means that you can sell one Euro for $1.2178 and buy one Euro for $1.2170. A dealer may not quote the full exchange rate for both sides of the spread. For example, the EUR/USD spread discussed above could be quoted as 1.2178/70. The customer should understand that the first three numbers are the same for both sides of the spread.