Direct and indirect quotation on the foreign exchange market
Forex and CFD trading has undergone significant changes during its existence. However, there are still principles that have not changed over the years and that are still worth knowing. Direct and indirect quotation is undoubtedly one of them. Based on this principle, one can tell whether the current exchange rate corresponds with the real market situation or not, and as such, it should be mastered by every trader.
For a better understanding, let’s demonstrate an exchange rate here and also give an explanation on how to understand it correctly.
The above mentioned exchange rate of the currency pair consists of:
- EUR – The base currency (always the first position of a currency pair), also referred to by some as the main or primary currency
- USD – The bid currency (always on the second position of the currency pair), sometimes also referred to as the secondary currency
- 1,2100 – exchange rate (expresses how many units of secondary currency are needed to exchange one unit of primary currency)
And now let’s closely inspect the problematics of direct and indirect quotations. The main question, of course, is what should we imagine under a direct quotation?
Direct vs Indirect quotation
Suppose you are a trader from the Czech Republic and you plan to go to the UK, for example, to go shopping. At this point, you need to exchange namely Czech crowns for pounds. Two situations can then occur at the exchange office:
The exchange office will state the exchange rate as the CZK / GBP ratio, which is a direct quotation for you as a Czech citizen, as this rate indicates how many pounds can be exchanged for selling one CZK.
Example: CZK/GBP = 0,033GBP
The exchange rate will be given in the GBP / CZK format, which means how many crowns can be bought for one pound. In this case, it is an indirect quotation for the Czechs and a direct quotation for the British.
Example: GBP/CZK = 30,3CZK
In simplicity, it can then be said that a direct quotation is an offer in which the domestic currency is kept as the base (primary) currency when being sold. When it comes to purchasing, this currency switches its place and is kept as a bid (secondary) currency.
How to calculate the exchange rate of direct and indirect quotations?
On stock exchanges and of course also in exchange offices, the exchange rates are usually stated in one format and it can therefore sometimes be difficult to find out whether the stated exchange rate for example USD / EUR = 0.92 corresponds to the value of the current traded exchange rate.
So how do you easily find out if the other party is offering us “the proper” exchange rate and does not want to “rob” us?
The rate at which the currency pair is being traded: Ask price - 1,100 (EUR / USD)
Exchange office rate: Bid price - 0.92 (USD / EUR)
If we take a look at what the "exchange rate given by the exchange office" will look like in the opposite format, the equation looks like this:
X=1 X=0,92Y -> Y= X/0,92 -> Y=1/0,92 -> Y=1,087 -> EUR/USD=1,087
As can be seen, while the current value at which the currency pair was being traded was around the level of 1,100 EUR / USD, the exchange office was willing to offer only 1.087 EUR / USD, which is more than 1% below the current traded value.
It is not possible to say whether the exchange rate offered by the exchange office is bad or good. In the end, everything depends on the law of supply and demand, i.e. on whether the counterparty still accepts this offer at a given moment, or not. And that is what modern trading is all about.