CFM7020 - Understanding foreign exchange: exchange rates
The spot market
Today, the world's major currencies, including the pound
sterling, the euro and the US dollar, float freely against each
other. This means that, like anything else traded on an open
market, a unit of currency is worth what people are prepared to pay
for it.
Currency traded for immediate delivery is said to be traded
on the spot market. The following are all examples of transactions
taking place at spot prices but not necessarily on the spot
market:
- A tourist exchanges Australian dollars for sterling at a bureau de change.
- A British businesswoman travelling in the USA uses her UK credit card to withdraw US dollars from a cash machine.
- A company receives payment in euros from an overseas customer. It immediately sells the euros to its bank, and an amount in sterling is credited to its current account.
- A currency dealer sells Japanese yen 100 million on the London foreign exchange market, and buys an equivalent amount of US dollars.
The price paid for a unit of currency on the spot market on a
particular day is often called the 'spot price'. But there is no
such thing as an official spot price, or an official exchange rate,
for any currency which is freely traded. The price will be what the
buyer and the seller agree. A major UK group buying $50 million
from a bank will be able to buy its dollars more cheaply, in
sterling terms, than a private individual buying $500 from the same
bank. A UK tourist buying euros from the reception desk of a
Spanish hotel, or tendering sterling for a purchase in euros, is
likely to get a worse rate of exchange than if he or she exchanged
sterling for euros at a bank.
In general, someone buying or selling currency will be quoted
two prices:
- the bid price - the price at which the bank or other dealer is prepared to buy the currency, and
- the offer price - the price at which it will sell.
Where you see reference to a spot rate of exchange, without further qualification, it usually means the rate mid-way between the bid and offer prices.
