How Foreign Exchange Prices Work

Currency quotes

An exchange rate is the price of one currency in terms of another. The one most familiar to you is probably the Australian dollar’s value in US dollars; for example one Australian dollar ($A1) has at various times in the recent past (a year or so) been worth between $US0.77 (77c) and $US1.02.

But if an Australian dollar is worth, say $US0.98, it also means that $US1.00 is worth about $A1.02 – to be exact, it’s $A1.0204, or the reciprocal of $US0.98 (the reciprocal can be calculated by dividing 1.0 by the rate, that is, 1.0/0.98 = 1.0204).

Because it’s vitally important to know which currency you’re buying and which you’re selling, there is a convention in the forex market to quote exchange rates on the basis that the first currency specified is the base currency (the one being valued).

Each currency has a universal three-letter code (the ISO code) that all foreign exchange participants use to identify it. The code for the Australian dollar is AUD and the US dollar is USD. Currencies are normally valued in terms of their US dollar equivalent. A rate involving two currencies other than the US dollar is called a cross rate (arrived at by comparing each one’s value with the US dollar) but the same convention applies. The base currency is the first of the pair and the quote is always for one unit of the base currency.

When you see a quote that looks like this: AUD/USD 0.9836 you know that what is being valued (the base currency) is one Australian dollar ($A1.00) and that its value is being given in terms of US dollars (the counter currency). From this we can be sure that $A1.00 = $US0.9836 (this is the same as an Aussie dollar being worth 98.36 US cents).

Most currencies (Japanese yen, Swiss francs, and Canadian dollars to name a few) are quoted with the US dollar as the base currency, but there are three notable exceptions: British pounds (GBP), euros (EUR) and Australian dollars (AUD). These, along with the New Zealand dollar, are quoted the other way around; for example: GBP/USD 1.5511 means that one British pound is worth $US1.5511

Remember it is the base currency that you are buying or selling when you trade in foreign exchange. You buy British pounds if you think they will rise in value against the US dollar, for example, and you sell them if you think they will fall in value. Although buying British pounds is the same as selling US dollars, if you always think in terms of how the base currency will move when placing your trade, you are less likely to get confused.

Spreads and Pips

When you go to the bank and request a foreign exchange transaction, the bank will give you two prices. It will sell you US dollars at one price, but if you want to sell them straight back the price offered will be lower – you will get less from the bank than what you paid for them.

The difference is called the spread. In foreign exchange terms, the spread is the difference between the price bid (price at which you can sell) and price asked (price at which you can buy). Other names for the same thing are the bid-ask spread or buy-sell spread.

It’s the same in the spot forex market, although the spreads are much smaller than you’ll get at the bank counter for small amounts of foreign currency. For example, if you see a quote written a EUR/USD 1.3100/03 this means the dealer or bank buys euros at $US1.3100 and you can sell at that price. It also means that the bank or dealer is willing to sell euros at $US1.3103. The spread is the difference, equivalent to three pips in this case.

Quotes are normally given to four decimal places (one exception is the yen, a unit which has much less value than the base units of other currencies). This means the smallest amount the Australian dollar, for example, can move against the US dollar is $US0.0001 (that is, the move from $US0.9705 to $US0.9706). This is the smallest move that a currency can make against another and is known as one pip. In the quotation we looked at above (EUR/USD 1.3100/03) the spread is three pips.

This is the cost of making a trade. It means the market must move by at least this amount before you begin to make a profit. Quotes can look a little different depending on the provider and type of software (or trading platform) you are using. The quote with the three-pip spread for euros might appear in any of the following ways:

EUR/USD 1.3100–03
EUR/USD 1.3100–1.3103
EUR/USD Buy 1.3100 Sell 1.3103
EUR/USD Bid 1.3100 Ask 1.3103

These all mean the same thing.

Major Currencies

The term major currencies is used to refer to the seven most liquid (most actively traded) currencies in the market. These are the US dollar (USD), British pound (GBP), Eurozone euro (EU), Japanese yen (JPY), Swish franc (CHF), Canadian dollar (CAD) and Australian dollar (AUD).
Minor Currencies

Minor currencies are all currencies other than the majors.

Commodity Currencies

Commodity currencies are those whose home countries rely heavily on commodity exports for a major share of their export income. According to IMF studies there are 58 countries which could be included here, but the active ones are the Australian dollar, Canadian dollar and New Zealand dollar.

Major Currency Pairs and Major Pairs

The term currency pairs often specifically refers to any pairs which include the USD, while a pair that doesn’t include the USD is a cross currency. Major pairs are the seven most liquid pairs: EUR/USD, USD/JPY, USD/CHF,GBP/USD, AUD/USD, NZD/USD and USD/CAD.
Trade sizes

Standard contract

In the spot forex market the typical size of a trade is the equivalent of $US100,000, where the base currency is US dollars. This typical trade unit size is known as a standard lot or standard contract. For Australian dollars, the base currency is the Australian dollar itself and the size of a deal is $A100,000 worth of the counter currency. At this contract size an initial margin of $A1000 is required and the value of a one-pip move is $US10.00 against that currency.

Mini contract

Many forex trading providers offer smaller contract sizes, including a mini contract or mini lot, for the equivalent of $A10,000, where an initial margin of $A100 is required and the value of a one-pip move is $US1.00 against that currency.

Micro contract

Becoming more readily available are micro contracts for the equivalent of just $A1000 and requiring an initial margin of $10. This allows traders with small accounts to enter into trades without exceeding their maximum loss limits, which are related to position size. A one-pip move at this lot size is equal to US10c against that currency.

*against the US dollar

Need to know

• Currencies are always quoted as a base currency (the first of a given pair), valued in terms of the counter or term currency (the second of the pair).
• The cost of trading is the spread (the difference between the buy and sell price).
• Always think in terms of whether the base currency, not the second currency, will rise or fall. In the AUD/USD pair, you may expect the US dollar to fall, but you need to translate this into what this means for the $A (if you think it will rise, you buy $A).

Thank you to Knowledge to Action for providing this information