The currency exchange rate convention used in this reading is P/B.

• B is the base currency.
• P is the price of the base currency.

For example, a USD/GBP rate of 1.5 indicates that one GBP is priced at 1.5 USD.

Bid-Ask Quotes and Spreads

Dealers (e.g., banks) do not normally charge a commission on their currency transactions, but they profit from the spread between the buying and selling rates on both spot and forward transactions. Quotes are always in pairs: the first rate is the buy, or bid, price (for a dealer); the second is the sell, or ask, offer (for a dealer).

• The ask rate is always higher than that bid rate, so the dealer can make a profit.
• The counterparty that asks for a two-sided price quote has the option, not the obligation, to deal at either the bid or ask price quoted to them.
• The bid-ask spread a client receives from a dealer is usually wider than the bid-ask spread a dealer receives from the interbank market. The dealer can use the interbank market to offset its position and get out of the risk exposure.

Sometimes the term pip is used to describe a spread. A pip is the smallest price change that a given exchange rate can make. Since most major currency pairs are priced to four decimal places, the smallest change is that of the last decimal point - for most pairs this is the equivalent of 1/100th of one percent, or one basis point.

The size of the bid-ask spread quoted to dealers' clients depends on three factors:

• The bid-ask spread in the interbank market for the pair. This factor depends on a few factors: the currency pair involved, the time of day, and the market volatility.
• The size of the transaction.
• The dealer-client relationship.

Triangular Arbitrage

A cross rate is the exchange rate between two countries computed from each country's exchange rate against a third country.

Example

The rate between Japanese JPY and the USD is JPY/USD = 80.0512 - 80.1230 and the rate between EUR and the USD is EUR/USD = 0.7920 - 0.7932. The quote between JPY and EUR will JPY/EUR = 80.0512/0.7932 = 100.9218, and 80.1230/0.7920 = 101.1654.

Note that in calculating the cross rates you should always assume that you have to sell a currency at the lower (or bid) rate and buy it at the higher (or ask) rate, giving you the worse possible rate.

Exchange traders are continuously alert to the possibility of taking advantage, through currency arbitrage transactions, of exchange rate inconsistencies in different money centers. These transactions involve buying a currency in one market at a lower price and simultaneously selling it in another at a higher price. As a result, the value of the bought currency will rise, while the value of the sold currency will fall. Such activities tend to keep exchange rates uniform in the various markets.

For example, suppose the following bid-ask quotes:

Market | Price Currency | Base Currency | Bid | Ask
New York | USD | GBP | 1.5712 | 1.5748
Toronto | CAD | USD | 1.0268 | 1.0312
London | CAD | GBP | 1.5617 | 1.5823

An astute trader would sell USD for CAD in Toronto, use the CAD to acquire GBP in London, and sell the GBP in New York. Specifically, the trader would:

• Begin in New York with USD1 million.
• Acquire CAD 1,026,800 for USD 1,000,000 in Toronto.
• Sell these CAD for GBP 648,928.8 in London (1,026,800 / 1.5823).
• Sell these GBP in New York for USD1,019,597 (648,928.8 x 1.5712).
• Get a profit of USD 19,597 with no investment and risk!

Absence of arbitrage requires the bid price is always lower than the ask price, no matter it is a dealer's quote, interbank quote, or implied cross rate quote.