In this article, we will explore some fundamental concepts to help importers and exporters operating internationally navigate the foreign exchange market. We will cover market conventions, different types of transactions, key mechanisms, and the pricing of currencies to facilitate better planning and decision-making.
Basic Notions of the Currency Market
The currency market (FX or forex) refers to the buying and selling of currencies against other currencies at current or predetermined prices. Currencies are always traded in pairs, meaning their value is relative.
The primary function of the foreign exchange market is to determine the price of one currency when exchanged for another. It is by far the largest market in the world, with daily trading volumes averaging $6.6 trillion as of April 2019 [1].
The Interbank Currency Market
The interbank market consists exclusively of financial institutions. It is a decentralized market where each financial institution records and manages its own transactions. The interbank market encompasses transactions between banks as well as transactions involving institutional investors, corporations, and retail clients through their financial institutions.
The activities of these market participants generate currency prices. Due to its volume and expertise, the interbank market influences all currency valuations.
Currency Market Pricing
Spot prices for currencies are generally quoted using between 4 and 6 significant figures. The EUR/USD currency pair, the most traded in the world, is quoted with 5 significant figures, for example, 1.20269.
Currencies have a bid price (the price at which a bank buys a currency) and an ask price (the price at which a bank sells a currency). For example:
| Bid | Ask |
|---|---|
| USD/CAD 1,21756 | 1,21761 |
The difference between the bid and ask price is called the spread. Spreads in the interbank market are very tight, unlike those offered by banks to their clients, which may include additional costs.
In this example, the bank is willing to buy USD in exchange for CAD at 1.21756 and sell USD for CAD at 1.21761. The spread is 0.00005.
Traders refer to the first part of the rate (up to two decimal places) as the big figure. In this case, it is 1.21. Dealers typically quote only the last two digits of the rate (three for some currency pairs), known as pips. In general, only pips are quoted during phone trading, while electronic trading systems display the full rate with pips highlighted.
How Transactions Work in the Currency Market
Some currencies are traded against each other as standard interbank currency pairs, meaning a price is always available. All other currency pairs are referred to as cross trades or cross pairings. Interbank transactions and most client transactions are always executed in amounts of the base currency (DEV1), regardless of the currency pair.
For example, even though CAD/USD is a standard currency pair quoted at 0.82132, a Canadian SME may need to process an amount in USD (DEV2) rather than in CAD (DEV1).
The indicated rate will remain the same, but instead of multiplying the CAD amount by the CAD/USD rate (CAD amount × 0.82132) to obtain a USD amount, the USD amount is divided by the CAD/USD rate (USD amount ÷ 0.82132) to obtain a CAD amount.
How to Calculate the Price of a Cross Trade?
It is important to note that the spread for a cross trade is always wider, as it includes the spread of both standard pairs from which it is derived.
Types of Transactions in the Currency Market
Most banks and brokers have a dedicated Foreign Exchange Sales and Trading Department. This department takes client orders (from businesses, investors, etc.), requests a quote from the trader (who has direct access to the interbank market), and then provides the quote to the client to decide whether to proceed.
There is a wide range of order types available: Market Orders: Orders executed immediately at current rates. Stop Orders: Orders to buy or sell at a specified price. Limit Orders: Orders to buy or sell at a specified price, executed at the limit price or better.
In recent years, online forex trading has become increasingly common. However, many SMEs still transact through their bank’s account manager or, depending on their size, directly with an institution’s trading desk.
[1] See the article: Currency Risk for SMEs: How to Assess Hidden Risks in Your Budget
For more information on managing currency risk, please refer to the article: How to manage currency risk and exchange rates
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