Spot Transactions in the Foreign Exchange Market
The foreign exchange market is a network that interconnects financial markets in an international setting that enables conversion of one currency to another, through an exchange rate. The economic activities of one country affect the exchange rate. The exchange rate is the cost of buying one unit of a foreign currency. Transactions in foreign exchange markets can be either a spot transaction or a forward transaction. The main difference between the two is the time when the transaction will be carried out.
A typical spot transaction involves a person buying foreign currency from his bank and then paying for it using his home currency. Another example is when a company receives a payment in foreign currency and then would sell it to a bank in exchange for the home currency. For transactions like these, knowing the current exchange rate is very important. Both scenarios are considered spot transactions because the exchange is immediately carried out. The transaction was made immediately in the market place at the market price.
The direct quote is usually used in spot transactions. It is the exchange rate that indicates the number of units of the home currency required to buy one unit of foreign currency. For a person living in the United States who is about to go on a trip to Europe, it is the amount of US dollars that he has to pay the bank in order to get one Euro. In contrast to the direct quote, the indirect quote is the exchange rate that expresses the required units of foreign currency to buy one unit of home currency. For the example above, if than person finishes the trip with remaining Euros and wishes to convert it back to US dollars once he gets back home, he will make use of the indirect quote.
There are two types of rates in the spot exchange market - the asked rate and the bid rate. The asked rate can also be referred to as the selling rate or the offer rate. This is the rate that the bank or trader asks from the buyer to pay for in home currency to purchase one unit of foreign currency. In this scenario, the bank is the seller. In the above example, the person will go the bank with his US currency to "buy" Euros. The bid rate is the rate at which the bank buys the foreign currency from a customer by paying in home currency. This time once the person goes home with his Euros, he would then "sell" it to a bank to get US $. This time, the bank becomes the buyer.