The post How to Calculate an Exchange Rate by Jay and Julie Hawk appeared first on Benzinga. Visit Benzinga to get more great content like this.
Currency exchange rates are determined by supply and demand in the huge foreign exchange or forex market, so they are generally quoted rather than calculated. You will need to get a quote to exchange one currency for another.
Where you can get an exchange rate quote from will largely depend on the amount of currency you are transacting and for what purpose. Read on for more information about getting an exchange rate quote so you can transact currencies.
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What is a Currency Exchange Rate?
An exchange rate quote expresses the cost of one currency expressed in terms of another currency. To exchange currencies, you need to first get an exchange rate quote that you can deal on.
Currencies trade actively against one another in pairs throughout the forex trading week that stretches from 5 p.m. on Sunday to 5 p.m. on Friday New York time. Since exchange rates change virtually all the time while the forex market remains open, keep in mind that a quote will generally not stay good for very long.
Furthermore, the market exchange rate of a currency pair for dealing wholesale amounts will probably differ significantly from the exchange rate you might get from your local bank or cambio when you exchange a small amount of foreign currency there for your personal needs.
This exchange rate divergence typically arises because those businesses tend to factor their significant costs in executing very small foreign currency transactions into the less attractive quote they give you.
How Do Exchange Rates Work?
To exchange currencies, you need to get an exchange rate quote for a currency pair. To read exchange rates correctly, you will need to know the base currency and the counter currency for the currency pair that corresponds to the quoted exchange rate you are looking at.
For example, if the base currency is U.S. dollars (code USD) and the counter currency is Canadian dollars (code CAD), you will be looking at a quote for the USD/CAD currency pair.
If the current offer side quote for USD/CAD is 1.3600, then that means it will cost you 1.3600 Canadian dollars to purchase 1 U.S. dollar. The USD/CAD exchange rate lets you know how many Canadian dollars it takes to buy one U.S. dollar.
Alternatively, if you want to calculate how many U.S. dollars it will cost you to buy one Canadian dollar or the CAD/USD exchange rate, then you need to take the reciprocal of the quoted USD/CAD exchange rate using the following equation:
CAD/USD exchange rate = 1 / (exchange rate for USD/CAD)
In the previous example where the USD/CAD exchange rate was 1.3600, the CAD/USD exchange rate would be 1/1.3600 or 0.7353. It will cost you 0.7353 U.S. dollars to purchase one Canadian dollar.
How to Find a Market Exchange Rate
Currency traders, corporations, funds, brokers and other financial institutions transact currencies in the forex market that operates around the clock during its trading week. To buy one currency in the forex market, you need to sell another currency for it so that an exchange takes place. The quoted rate of exchange or exchange rate for a currency pair is determined by the market forces of supply and demand.
For personal currency conversion transactions for travel or foreign purchases, you can probably get a currency exchange rate quote at a local cambio or bank that offers a money exchange service for smaller amounts. You can also use your credit card to make purchases abroad in a foreign currency. You can even exchange some currencies via electronic payment companies like PayPal.
If you want to know how find a market exchange rate because you intend to trade forex, then you can generally do so via an online forex broker. If your average transaction volume is closer to wholesale amounts of $1 million, then you can probably contact a financial institution you have a relationship with. Its forex dealing desk might agree to take you on as a client and act as a forex market maker for you.
How Conversion Spread Impact Exchange Rates
When converting one currency into another, the difference between the exchange rate that a forex market maker will buy the base currency in a currency pair at and the rate it will sell the pair at is known as the dealing spread.
Since most forex market makers, brokers, cambios and banks do not charge commissions for currency exchange transactions, they instead typically widen their dealing spreads to cover their costs and make a profit when you deal on their quote.
When you go to your local bank or cambio to convert currencies, you probably will not get quoted the tight market dealing spread that professional forex traders get. The business you are dealing with will mark up the exchange rate so they can make a profit. This is analogous to your gas station selling gas at a higher price than they buy it at.
Exchange Rate Formula
Exchange rates are generally quoted rather than calculated, so they will probably already be calculated for you to deal on. If you want to calculate an exchange rate yourself, you can take the amount of a currency you want to exchange and divide it by the amount of the other currency you will receive in return to give you the exchange rate per the following exchange rate formula:
Exchange rate = Amount of currency A exchanged/Amount of currency B received
As an example, consider an American tourist visiting the U.K. who has $1,000 to exchange for British pounds sterling at a cambio. When they sell the dollars, they get 950 pounds back, so the effective GBP/USD exchange rate they received for their dollars was $1,000 divided by 950 pounds or 1.0526 dollars per pound.
That GBP/USD quotation of 1.0526 reflects the amount of dollars required to purchase 1 pound sterling, and it reflects the conventional way that particular currency pair is quoted in the forex market. Alternatively, if you wanted to calculate USD/GBP, or the amount of pounds required to purchase 1 dollar, then you would take the reciprocal of the 1.0526 GBP/USD exchange rate, which yields a rate of 0.9500.
You might also want to know how to compute the amount of foreign currency you will get based on a quoted exchange rate. In the above example, the American tourist would have been quoted an exchange rate of 1.0526 by the cambio attendant for them to buy pounds sterling and sell their dollars.
Knowing this quote, the tourist can then calculate the amount of pounds they will receive for the $1,000 they want to sell by dividing the dollar amount by the exchange rate— 1000/1.0526 — to get a pound sterling amount of 950 pounds.
What are the Most Popular Currency Pairs?
If you are thinking of getting into forex trading, then you will probably want to get a sense of the most popular currency pairs to trade speculatively. Forex traders usually refer to these pairs as the “majors” because of their large daily transaction volumes and high market liquidity.
The way that the currency codes are ordered in a pair is the traditional way they are quoted in the forex market. For example, the most popular currency pair that includes the U.S. dollar or greenback is the EUR/USD where the dollar trades versus the EU’s euro. The euro serves as the base currency in this pair that is conventionally quoted in terms of the U.S. dollars required in exchange for 1 euro.
Also popular among forex traders are the GBP/USD, USD/JPY, USD/CHF, AUD/USD, USD/CAD and NZD/USD pairs where the dollar trades respectively versus the U.K.’s pound sterling, the Japanese yen, the Swiss franc, the Australian dollar, the Canadian dollar and the New Zealand dollar. Some popular crosses — which are currency pairs that do not include the U.S. dollar — include EUR/GBP, EUR/CHF, AUD/JPY and GBP/AUD.
Be in the Know About Exchange Rates
Whether you are new to forex trading or a seasoned trader, having a firm understanding of how to calculate the exchange rate is a must. The exchange rate will give you insight into how to better calculate your traders and how much profit you can expect to earn on winning trades.
Need a reputable forex broker to execute currency trades? Check out Benzinga’s list of Best Forex Brokers.
Frequently Asked Questions
How do you manually calculate foreign exchange rates?
Since exchange rates are determined by supply and demand in the forex market, they are quoted rather than calculated. With that noted, you can calculate the fair value of a cross exchange rate by using the exchange rates of each component currency quoted against the U.S. dollar.
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Do you multiply or divide to convert currency?
It depends on what currency your notional amount is denominated in and the pair of currencies you are exchanging. For example, if you have pounds sterling (GBP) that you intend to exchange for U.S. dollars (USD), you will multiply the bid side of the GBP/USD exchange rate by the amount of pounds you wish to exchange to get the resulting dollar amount. Alternatively, if you wish to exchange dollars for pounds, you will need to divide by the offer side of the GBP/USD exchange rate to get the resulting pound amount.
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Where can I check exchange rates?
You can check the current level of exchange rates online by doing a simple Google search for the currency pair you are exchanging, such as GBP/USD for the pound sterling/US dollar rate, and the phrase “exchange rate.” Some newspapers, such as the Wall Street Journal, also publish closing exchange rates. If you are looking for the net exchange rate that Visa will charge you on a foreign credit card transaction including fees, then you can go to Visa’s exchange rate calculator page linked here.
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The post How to Calculate an Exchange Rate by Jay and Julie Hawk appeared first on Benzinga. Visit Benzinga to get more great content like this.
