T2W Trading Community

The spot market accounts for nearly a third of global foreign exchange turnover. It can be broadly divided into two tiers:

• The interbank market where currency is bought and sold for delivery and settlement within two days, with the banks acting as “wholesalers” or “market makers”.
• The retail market made up of private traders, who deal over the telephone or the internet through intermediaries (brokers).

The forex market has no centralised exchanges. All trades are over-the-counter deals, agreed and settled by individual counterparties known to one another. The forex market is truly global and operates 24 hours a day, Monday to Friday. Daily trading commences in Wellington, New Zealand and follows the sun to (inter alia) Sydney, Tokyo, Hong Kong, Singapore, Bahrain, Frankfurt, Geneva, Zurich, Paris, London, New York, Chicago and Los Angeles before starting again.

1. Currency pairs and the rate of exchange

Every foreign exchange transaction is an exchange between a pair of currencies. Each currency is denoted by a unique three-character International Standardisation Organisation (ISO) code (e.g. GBP represents sterling and USD the US dollar). Currency pairings are expressed as two ISO codes separated by a division symbol (e.g. GBP/USD), the first representing the “base currency” and the other the “secondary currency”.

The rate of exchange is simply the price of one currency in terms of another. For example GBP/USD = 1.5545 denotes that one unit of sterling (the base currency) can be exchanged for 1.5545 US dollars (the secondary currency). The base currency is the one that you are buying or selling. This elementary point is often lost on beginners.

Exchange rates are usually written to four decimal places, with the exception of Japanese yen which is written to two decimal places. The rate to two (out of four) decimal places is known as the “big figure” while the third and fourth decimal places together measure the “points” or “pips”. For instance, in GBP/USD = 1.5545 the “big figure” is 1.55 while the 45 (i.e. the third and fourth decimal places) represents the points.

1.1 Bid offer spread

As with other financial commodities, there is a buying price (“offer” or “ask” price) and a selling price (“bid” price). The difference is known as the “bid-offer spread” or “the spread”.

The spread is written in a particular format, best demonstrated by way of an example. GBP/USD = 1.5545/50 means that the bid price of GBP is 1.5545 USD and the offer price is 1.5550 USD. The spread in this case is 5 points.

1.2 The major pairings

All pairings with the US dollar are known as the “majors”. The “big four” majors are: 

EUR/USD denoting Euro/US Dollar
GBP/USD denoting Sterling/US Dollar (known as “cable”)
USD/JPY denoting US dollar /Japanese Yen
USD/CHF denoting US dollar/Swiss Franc

1.3 Cross rates

Pairings of non-US dollar currencies are known as “crosses”. We can derive cross exchange rates for GPB, EUR, JPY and CHF from the aforementioned major pairs. Exchange rates must be consistent across all currencies, or else it will be possible to “round trip” and make riskless profits.

The following “major” exchange rates (red) imply the “cross rates” (blue). An illustration of how cross rates are computed is given in Appendix A.