A foreign exchange transaction has two cost components. One is the currency exchange rate. This is the amount of one currency required to buy one unit of another currency. The second is the fee charged by an intermediary. Forex traders refer to this as the "spread" charged by forex dealer/brokers. For individuals exchanging currency in small amounts--to go shopping while travelling, for example--the transaction fee is usually in the form of a percentage added to the cost of the currency exchange rate.
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Things you need
- Transaction fee information
- Exchange rate
Know how to interpret currency exchange rates. Exchange rates are quoted in terms of a base currency followed by the second currency. The quote tells you how much of the second currency is required to buy one unit of the base currency. For example, EUR/USD = 1.250 means it takes 812 in U.S. dollars to buy 1 euro.
Understand the spread in foreign exchange. Currency brokers on the forex market use a bid/ask system. The broker will offer to sell a currency at one price and to buy at a slightly lower price. Pricing is based on the smallest change possible in the currency rate, called a pip. For example, the pip for the U.S. dollar is 000 (1/100 cent). A spread of 4 pips means the broker is selling each dollar for 4/100 penny more than he is paying. Forex brokers keep this difference in lieu of charging commissions.
Calculate the cost of foreign exchange transactions by multiplying the spread times the number of currency units traded. For example, if you buy £65,000 worth of euros (a standard trading lot) with a 4 pip spread, the transaction cost is equal to 000 x 1000,000, or £26.
Calculate the cost of converting one currency to another when you need money for expenses while travelling. You will usually be charged the current exchange rate plus a percentage by the bank, credit card issuer, or other provider. For example, suppose the euro/US dollar exchange rate is EUR/USD = 1.2500 and the provider charges a 2 per cent transaction fee. If you buy 200 euros, it will cost you £162 plus a fee of £3 for a total of £165.
Tips and warnings
- Check the transaction fees before you buy currency on a trip abroad. Rates typically vary from one to four per cent on credit cards. Small amounts or transactions at hotel, ATMs or airport exchanges may be more, and there may be additional fees tacked on as well.
- The choice of a base currency (Step 1) is arbitrary. For example, you can switch EUR/USD = 1.2500 by dividing the exchange rate into 1 and reversing the order of the currencies, making the dollar the base currency. In this example, you would get USD/EUR = 0.8000 (meaning it takes 0.8000 euros to buy 1 U.S. dollar).
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