Calculating the price of simple everyday physical items is pretty straightforward. You simply multiply the number of items by their cost to arrive at a money value for the exchange.
However, buying and selling currency requires a different type of calculation to arrive at an exchange rate, which can leave many investors perplexed or simply put them off to buying and selling currency altogether, thus missing out on a potentially lucrative investment opportunity.
Not to mention, you will also be exposed to currency exchange rates if you plan to make purchases abroad, such as while traveling. Therefore, it is worth it to take the time to understand currency exchange rates in their most basic form, which the following brief explanation will help you do.
Buying currency means exchanging money for money, which requires the application of an exchange rate. And whatever currency is used will create a pair.
For instance, if USD dollars are used to buy British pounds, the exchange rate is USD/GBP for the pair.
To read the exchange rate, let’s say the USD/GBP pair is 1.05. This means it costs 1.05 British pounds to purchase 1 US dollar.
Usually, the base currency is the first listed in the exchange quote, and it always represents 1 unit of that currency.
Meanwhile, the exchange rate simply shows how much of the second listed currency is needed to purchase 1 unit of the base currency.
When you convert currencies at a financial institution, such as a bank, a markup will be added to the market price, which enables them to make a profit.
This discrepancy between the market price and the markup price is called a conversion spread. To calculate the conversion spread, take the difference between the market exchange rate and the markup exchange rate and divide it by the market exchange rate.
For instance, let’s say the market exchange rate is 1.25 GBP to buy 1 USD dollar (USD/GBP), and the financial institution is charging 1.30 GBP to purchase 1 USD dollar, then the discrepancy is 0.05 (1.30 – 1.25).
Next, divide the difference by the market exchange rate (0.05/1.25), which equals 0.04.
Now multiply 0.04 by 100 (0.04 x 100) to get a conversion spread percentage of 4%.
The closer the exchange rate is to the market exchange rate, the more money you save.
There are two ways to convert foreign currency, from the base and to the base.
When converting from the base currency, we multiply by the exchange rate. So if we need to convert 8 British Pounds into US dollars, and the exchange rate is GBP/USD 1.20, then we multiply 8 GBP x 1.20 per British pound = 9.6 GBP.
When converting to the base currency, you simply divide by the exchange rate.
You can also use a currency calculator such as the one provided on the Western Union website, to calculate currency exchange rates.
Now that the mystery of reading and calculating currency exchange rates has been dispelled, you can go out and expand your world with confidence.