What Is the Bid-Ask Spread In Retail Currency Exchange?
The bid-ask spread (informally referred to as the buy-sell spread) is the difference between the prices at which a dealer will buy and sell a currency in the foreign exchange (forex) market. However, the spread, or the difference, between the bid price and ask price for a currency in the retail market can be large, and may also vary significantly from one dealer to the next.
Understanding how exchange rates are calculated is the first step to understanding the impact of wide spreads in the foreign exchange market.
Key Takeaways
- In retail currency exchange, bid price and ask price are two different exchange rates that currency dealers offer.
- The bid price is what a dealer will pay for a currency. The ask price is what the dealer will sell a currency for.
- The bid-ask spread (or the buy-sell spread) is the difference between the price at which a dealer is willing to sell a currency versus the price at which they will buy it.
- The larger the bid-ask spread, the more profit a currency dealer will make. The smaller the spread, the better the exchange rate is for customers.
- Exchange rates and bid-ask spreads vary by dealer.
How Bid-Ask Spreads Work In the Retail Forex Market
The bid price is what a dealer is willing to pay for a currency, while the ask price is the rate at which a dealer will sell the same currency.
For example, when travelers at an airport want to exchange their money for the local currency, they are actually purchasing or selling at the price set by the currency dealer. Imagine a currency kiosk at an airport is offering:
EUR 1 = USD 1.30 / USD 1.40
The higher price (USD 1.40) is the cost in USD (United States dollars) to buy each euro, or the ask price. The lower price (USD 1.30) is the amount the kiosk owner is willing to pay for each euro, or the bid price.
If Traveler A is about to fly to Europe and wants to exchange dollars for €5,000. The ask price is $1.40, so they will have to pay $7,000.
However, if Traveler B is just returning from Europe and wants to exchange €5,000 for dollars, they will be given the bid price of $1.30 per one euro, or $6,500. Even though the euro amount is the same for the two travelers, the difference between the bid price and the ask price, or the bid-ask spread, means that the dollar amounts are different. The bid-ask spread allows the kiosk owner to make a profit of $500 ($7,000 - $6,500) between these two transactions.
When faced with a standard bid and ask price for a currency, the higher price is what you would pay to buy the currency and the lower price is what you would receive if you were to sell the currency.
Rates can vary between dealers in the same city, and the smaller the bid-ask spread, the better the exchange rate a dealer is offering to retail customers. These bid-ask variations add up to a significant amount of money when it comes to exchanging currency.
Some dealers will automatically improve the posted rate for larger amounts; others may only offer this if a customer specifically requests a rate improvement.If you haven’t had the time to shop around for the best rates, research ahead of time so you have an idea of the spot exchange rate and understand the spread. If the spread is too wide, consider taking your business to another dealer.
Direct and Indirect Currency Quotes in Forex Markets
A direct quote, also known as a “price quotation,” expresses the price of a unit of foreign currency in terms of the domestic currency. An indirect currency quote, also known as a “volume quotation,” expresses the amount of foreign currency per unit of domestic currency.
Most currencies are quoted in direct quote form (for example, USD/JPY, which refers to the amount of Japanese yen per one U.S. dollar). The currency to the left of the slash is called the base currency and the currency to the right of the slash is called, the counter currency, or quoted currency.
Commonwealth currencies such as the British pound and Australian dollar, as well as the euro, are generally quoted in indirect form (for example, GBP/USD and EUR/USD, which refer to the amount of US dollars per one British pound and per one euro).
Consider the Canadian dollar. In Canada, this quotation would take the form of USD 1 = CAD 1.0750. This represents a direct quote, since it expresses the amount of domestic currency (CAD) per unit of the foreign currency (USD). The indirect form would be CAD 1 = USD 0.9302.
Next, consider the British pound. In the United Kingdom, this quotation would take the form of GBP 1= USD 1.700. This represents an indirect quotation since it expresses the amount of foreign currency (USD) per unit of domestic currency (GBP). The direct form of this quote would be USD 1 = GBP 0.5882.
How to Use Currency Quotes
When dealing with currency exchange rates, it's important to have an understanding of how currencies are quoted.
Suppose there is a Canadian resident who is traveling to Europe and needs euros. The exchange rates in the forex market are approximately
USD 1 = CAD 1.0750
EUR 1 = USD 1.3400
That means the approximate EUR/CAD spot rate would be
EUR 1 = CAD 1.4405 (1.3400 x 1.0750)
A currency dealer in Canada might quote a rate of EUR 1 = CAD 1.4000 / 1.4800, which means that you would pay 1.48 Canadian dollars to buy one euro and would receive 1.40 Canadian dollars if you sold one euro.
The calculation would be different if both currencies were quoted in direct form. If the approximate spot rate for the Japanese yen is USD 1 = JPY 102, this is how you would calculate the price of yen in Canadian dollars:
USD 1 = CAD 1.0750 and USD 1 = JPY 102
Thus:
CAD 1.0750 = JPY 102, or CAD 1 = JPY 94.88 (102 / 1.0750)
In general, dealers in most countries will display exchange rates in direct form, or the amount of domestic currency required to buy one unit of a foreign currency.
How to Calculate Cross-Currency Rates
When dealing with cross currencies, first establish whether the two currencies in the transaction are generally quoted in direct form or indirect form.
If both currencies are quoted in direct form, the approximate cross-currency rate would be calculated as:
(Currency A) / (Currency B)
If one currency is quoted in direct form and the other in indirect form, the approximate cross-currency rate is calculate as:
(Currency A) x (Currency B)
When you calculate a currency rate, you can also establish the spread, or the difference between the bid and ask price for a currency. More importantly, you can determine how large the spread is. If you decide to make the transaction, you can shop around for the best rate.
How Does the Bid-Ask Spread Relate to Exchange Rates?
When you are exchanging currencies, the bid-ask spread provides two different exchange rates. The bid price is the exchange rate the dealer will pay to buy a currency from you; the ask price is the exchange rate you must pay to buy that same currency from the dealer. Different dealers will offer different exchange rates, even within the same city. The smaller the bid-ask spread, the less profit for the dealer but the more favorable the exchange rate for the customer.
How Can I Get a Good Currency Exchange Rate When Traveling?
In general, travelers will get the best exchange rate if they avoid exchanging currency at the airport. Airport kiosks have the worst exchange rates, with extremely wide bid-ask spreads. It's possible to receive 5% less of the currency you are buying. If you can carry a small amount of the local currency for immediate needs, or use a credit or debit card, you can then exchange bigger amounts at banks or dealers in the city where you are traveling.
Do I Buy at Bid or Ask?
The bid price is the price a buyer will pay. The ask price is the price at which a seller will sell. The bid-ask spread is the difference between these two prices and determines the profit buyers and sellers can make.
The Bottom Line
In retail currency exchange, dealers offer two different exchange rates: the price they offer for a currency (the bid price) and the price they will accept for a currency (the ask price). The difference between these prices is known as the bid-ask spread.
Wide spreads are the bane of the retail currency exchange market. A larger bid-ask spread means a dealer can make a larger profit but customers are offered a less favorable exchange rate. A lower bid-ask spread is more favorable to customers but less favorable to dealers. Customers can get a better exchange rate by researching the best rates, foregoing airport currency kiosks, and asking for better rates for larger amounts.
