Calculating Foreign Exchange Spread

What is the Foreign Exchange Spread?

The foreign exchange spread is the percent difference between the highest price a buyer is willing to pay (the bid) and the lowest price sellers are willing to sell (the ask) a currency pair at one specific moment. In all cases, the ask is lower than the bid.

A currency pair is the price quote of the exchange rate of two currencies traded in the foreign exchange market. It should be no surprise that the most traded currency pairs all include the USD, given its role in international markets.

The five most traded currency pairs are as follows:

1. EUR/USD
2. USD/JPY
3. GBP/USD
4. AUD/USD
5. USD/CAD

Movements in the prices of currency pairs, whether in terms of the spread between the bid and ask or just in terms of its value, are tracked by pips, the smallest whole unit of measurement for these changes. A pip is equal to 1/100 of 1%, or .0001.

The reason why pips are such a small percentage is because of the relative stability of many currencies. Unlike stocks and cryptocurrencies, whose values can surge or plummet by massive percentage points, currency pairs typically remain quite stable. 

The stability of currency pairs explains why investors are so highly leveraged in the markets. If they were not so massively leveraged, their gains would be minuscule compared to other markets. 

For most stable currency pairs, such as EUR/USD, the leverage ratio is extremely high, typically around 27:1. This means that even small pip changes can have a massive impact on the amount of money made or lost. 

How to Calculate Foreign Exchange Spreads

The difference between the asking and bid prices is measured in pips. However, the spread could also be calculated in terms of percentages. 

Understanding the concept of the foreign exchange spread is essential to understanding how the market functions. Therefore, it is vital to know the formula to calculate it, which is the following: 

Spread % = (Ask Price - Bid Price)/ Ask price * 100   

What this formula gives you is really just the difference between the ask price and the bid price as a percentage. In the international currency markets, this is what the foreign exchange spread is. This spread is known as the bid-ask spread or, informally, the buy-sell spread.

The impact that these spreads has gone far beyond just general investors and traders. Foreign exchange spreads are at play when people from any country go and visit another country with a different currency. 

When going on vacation, tourists usually need to buy foreign currency to travel and purchase goods in the other country. This is done through a kiosk dealer. To best understand how these spreads function in traveling, it is important to give an example. 

To preface this example, the currency asks and bid prices are not exact.

For example, an American, Susan, will be traveling to England for vacation. The current exchange is 1 GBP = USD 1.2 / USD 1.3. Susan goes to a kiosk dealer and has to buy the GBPs at a higher price. This leads to 1300 USDs being swapped for 1000 GBPs. 

After this exchange, another American, John, has just returned from England and would like to exchange his GBPs for USDs. John has to sell 1000 GBP back to the kiosk at the 1.2 rate to receive 1200 USD. The kiosk’s overall profits by 1300 - 1200 = 100 USD.

How Are Foreign Exchange Spreads Quoted?

Foreign currencies can be quoted directly or indirectly, but what exactly does each mean? This distinction between these two terms is truly at the core of foreign currencies and is highly applicable to real-world applications.

Direct currency quotes are often referred to as “price quotations.” These quotes are foreign exchange rates quoted in the domestic currency. This simplifies the understanding of how much domestic currency will need to be paid in exchange for desired foreign currency.

Indirect currency quotes are the precise opposite of direct currency quotes - they represent how much domestic currency you can buy in exchange for foreign currency. Understanding this helps comprehend currency transactions in the real world beyond just trading. 

The clear distinction in the example given in the previous section, in which one person was purchasing foreign currencies to travel to another country and the other was exchanging a foreign currency for their domestic currency, is that of direct and indirect quotations.

Factors That Impact Foreign Exchange Spread

The foreign exchange market is subject to an enormous amount of risk. This is because, unlike stocks mainly based on individual company performance or large macroeconomic trends, the factors impacting international currency markets are far more varied. 

If you want real-world examples of this occurring, look no further than what happened to the GBP in the past year. Engaging in a case study of how the GBP moved and why should reveal how different factors can dramatically affect currency prices.

The foreign exchange market has become more exciting within the past few years. Foreign currency markets were typically seen as dull and slow, mainly because most developed countries’ currencies have been stable for the past couple of decades.

However, in recent years, these markets have been far more volatile than they typically are between the pandemic, Russia’s invasion of Ukraine, and other events.

Below are the main factors that impact the swings in currency prices:

Fluctuations In Trading Volume

Whether trading volume increases or decreases dramatically, it significantly impacts the spread of a specific currency pair. The reason for this comes down to how liquid the currency is.

If there is a higher trading volume, the currency is very liquid as it is bought and sold. This means that the spread between the bid and ask will be lower.

However, if a currency is experiencing low trading volume, fewer people are buying and selling the currency, leading to the spread between the bid and ask to increase. 

On the subject of trading volume, the daily trading volume of the foreign exchange market is 6.6 trillion USD, a number that greatly outsizes even the daily trading volume of the stock and bond markets. As a result, the worldwide market is worth 2.4 quadrillion USD. 

Political And Macroeconomic Risks

The strength of a nation’s currency is directly tied to its political stability and approach to macroeconomic policy. Countries with unstable governments tend to have weaker macroeconomic policies. All of this leads to instability in the nation’s currency.

Some of the key macroeconomic risks are rampant inflation and sizable national debt. Of course, rampant inflation devalues a currency. The higher the prices become, the poorer the citizens become.

Inflation is a product of poor macroeconomic policy and an accelerator. For example, certain countries, such as Zimbabwe and Venezuela, have experienced an insane level of inflation and poor macroeconomic responses to that inflation, which has destroyed the value of their currency.

Additionally, the high national debt can destroy any currency’s prices. The high national debt can lead to countries defaulting on their debts and being unable to repay them. This can lead to the country being excluded from future credit and may have assets seized.  

The foreign exchange spread, therefore, shifts depending, again, on the trading volume of the currency pair.

Researched and authored by Adrian de Vernou | LinkedIn

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