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.
How can I trade foreign currency exchange rates?
As you can see from the example, currency exchange rates fluctuate.
As the value of one currency rises or falls relative to another,
traders decide to buy or sell currencies to make profits. Retail
customers also participate in the forex market, generally as speculators
who are hoping to profit from changes in currency rates.
Foreign currency exchange rates may be traded
in one of three ways:
1. On an exchange that is regulated by the Commodity
Futures Trading Commission (CFTC). For example, the
Chicago Mercantile Exchange offers forex futures and
options on futures products. Exchange-traded forex futures
and options provide their users with a liquid, secondary
market for contracts with a set unit size, a fixed expiration
date and centralized clearing.
2. On an exchange that is regulated by the Securities and
Exchange Commission (SEC). For example, the
Philadelphia Stock Exchange offers options on currencies
(i.e., the right but not the obligation to buy or sell a
currency at a specific rate within a specified time).
Exchange-traded options on currencies have characteristics
similar to exchange-traded futures and options (e.g., a
liquid, secondary market with a set size, a fixed expiration
date and centralized clearing).
3. In the off-exchange, also called the over-the-counter
(OTC), market. A retail customer trades directly with a
counterparty and there is no exchange or central clearing
house to support the transaction. Off-exchange trading is
subject to limited regulatory oversight.
This brochure focuses on the off-exchange foreign currency market.
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