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The Foreign Exchange Rate By: Direct and Indirect Methods of FX Quotation

Articulation of foreign exchange rate

By the direct method of FX quotation, the foreign exchange rate is articulated as the number of units of the home currency required to get one unit of the relevant foreign currency. In the United States, this technique is also called as quoting the foreign exchange rate in American terms. By the indirect method of FX quotation, the foreign exchange rate is articulated as the number of units of the relevant alien currency required to obtain one unit of the home currency. In the United States, this technique is also called as quoting the foreign exchange rate in alien terms.

Calculation of direct and indirect quotes

Assume that you are offered the direct quote, in United States terms, between the Euro and the United States dollar as:

¬1.00 = $1.2830

The indirect quote between the United States dollar and the euro would then be computed as the reciprocal (1 / 1.2830), to get the indirect quote for the United States dollar as:

$0.7794 = ¬1.00

Suppose you are given the following indirect alien exchange quote for the United States dollar and the Japanese yen, from a Japanese point of view:

¥109.38 = $1.00

The direct exchange quote for the currency of Japan, the Yen to United States dollar, from a Japanese point of view, will be the reciprocal of (1 / 109.38), and you then obtain:

$0.009142 = ¥1.00

Ways of computing Spread on an alien Currency Quote

Earnings for currency market dealers are based on the disparity between the bid, which is the rate of exchange at which a trader is enthusiastic to buy a particular currency, and the ask, which is the rate of exchange for which a trader is anxious to sell a meticulous currency. Then the bid-ask spread is the difference between these two. Foreign currency traders will quote both ask and bid for a meticulous currency. The mean of ask and bid is known as the midpoint price. The bid-ask spread is classically given as a proportion and it is computed as:

 

Percentage of spread = 100 x {(Ask Price – Bid Price)} / Ask price

 

Suppose that a trader offers the following quote in the United States dollars for Euros to dollars:

Direct ($/¬): $0.8038/$0.8041

Then the bid-ask spread will be computed as 100 × (0.8041 – 0.8038) / 0.8041 = 0.0373%, which is about four basis points.

Factors affecting the spreads’ size
Factors that have an effect on the size of the spreads for forward and spot rates of exchange of currencies include:

  • Currency Rate instability – By higher volatility, currency traders are exposed to elevated risk. Spreads will swell with higher instability.
  • Trading capacity – The higher the capacity, the lower the bid-ask spread.
  • Alleged Political/Economic Risks – Risks like political volatility, high inflation and varying economic situations will have an effect on the spreads connected with a particular currency. The higher the ambiguity, the larger the expected spread.

 

 

 

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