THE FOREIGN CURRENCY MARKETS

What are foreign currency exchange rates?

Foreign currency exchange rates are what it costs to exchange one
country’s currency for another country’s currency. For example, if
you go to England on vacation, you will have to pay for your hotel,
meals, admissions fees, souvenirs and other expenses in British
pounds. Since your money is all in US dollars, you will have to use
(sell) some of your dollars to buy British pounds.

Assume you go to your bank before you leave and buy $1,000
worth of British pounds. If you get 565.83 British pounds
(£565.83) for your $1,000, each dollar is worth .56583 British
pounds. This is the exchange rate for converting dollars to pounds.
If £565.83 isn’t enough cash for your trip, you will have to
exchange more US dollars for pounds while in England. Assume
you buy another $1,000 worth of British pounds from a bank in
England and get only £557.02 for your $1,000. The exchange rate
for converting dollars to pounds has dropped from .56583 to
.55702. This means that US dollars are worth less compared to the
British pound than they were before you left on vacation.

Assume that you have £100 left when you return home. You go to
your bank and use the pounds to buy US dollars. If the bank gives
you $179.31, each British pound is worth 1.7931 dollars. This is
the exchange rate for converting pounds to dollars.

Theoretically, you can convert the exchange rate for buying a currency
to the exchange rate for selling a currency, and vice versa, by
dividing 1 by the known rate. For example, if the exchange rate for
buying British pounds with US dollars is .56011, the exchange rate
for buying US dollars with British pounds is 1.78536 (1 ÷ .56011
= 1.78536). Similarly, if the exchange rate for buying US dollars
with British pounds is 1.78536, the exchange rate for buying
British pounds with US dollars is .56011 (1÷ 1.78536 = .56011).

This is how newspapers often report currency exchange rates.
As a practical matter, however, you will not be able to buy and sell
the currency at the same price, and you will not receive the price
quoted in the newspaper. This is because banks and other market
participants make money by selling the currency to customers for
more than they paid to buy it and by buying the currency from
customers for less than they will receive when they sell it. The
difference is called a spread and is discussed later in this booklet.