Understanding corporate finance: foreign exchange: floating exchange rates
Floating rates: the spot market
Today, the world’s major currencies, including the pound sterling, the euro and the US dollar, float freely against each other. This means that, like anything else traded on an open market, a unit of currency is worth what people are prepared to pay for it.
Currency traded for immediate delivery is said to be traded on the spot market. The following are all examples of transactions taking place at spot prices but not necessarily on the spot market:
- A tourist exchanges Australian dollars for sterling at a bureau de change.
- A British businesswoman travelling in the USA uses her UK credit card to withdraw US dollars from a cash machine.
- A company receives payment in euros from an overseas customer. It immediately sells the euros to its bank, and an amount in sterling is credited to its current account.
- A currency dealer sells Japanese yen 100 million on the London foreign exchange market, and buys an equivalent amount of US dollars.
The price paid for a unit of currency on the spot market on a particular day is often called the ‘spot price’. But there is no such thing as an official spot price, or an official exchange rate, for any currency which is freely traded. The price will be what the buyer and the seller agree. A major UK group buying $50 million from a bank will be able to buy its dollars more cheaply, in sterling terms, than a private individual buying $500 from the same bank. A UK tourist buying euros from the reception desk of a Spanish hotel, or tendering sterling for a purchase in euros, is likely to get a worse rate of exchange than if he or she exchanged sterling for euros at a bank.
In general, someone buying or selling currency will be quoted two prices:
- the bid price - the price at which the bank or other dealer is prepared to buy the currency, and
- the offer price - the price at which it will sell.
Where you see reference to a spot rate of exchange, without further qualification, it usually means the rate mid-way between the bid and offer prices.
London closing rate
The Financial Times publishes (on a daily basis for the major currencies - reference rates) the rates of exchange for different currencies against the pound. These represent the spot rate of exchange determined by trading in the London FOREX market, when the market closed the previous day. The mid- point quotation is given, as well as the actual bid and offer prices. This mid-point price for each currency is referred to as the London closing rate.