There are different facets of currency – it is the unit of money, the medium of exchange, can be an asset class for investment.
A currency may play a role as “reserve currency” by central banks, “transaction currency” for international currency markets, “invoice currency” for contracts and “intervention currency” for market operational by central banks.
At its core, Foreign Exchange means exchanging one currency for another. The primary reason for foreign exchange is international trade. Say, you are an Indian student who is studying in the USA. You took a loan from an Indian bank for paying for the fees and your lifestyle costs. Now, the US institution will not accept Indian Rupees, neither the merchants in the US will sell you stuff in exchange for the Indian rupees. So, you need to get US Dollars in exchange for Indian Rupees. This is the primary purpose foreign exchange serves.
As trading in Foreign Exchange is basically buying a currency by paying in terms of other currency. The price of a physical good or security in a domestic market is defined in terms of a single currency. For example, a pen for Rs. 20.
Now, say you have to buy US dollars. But, how do you pay for that? Currency trading is done using currency pairs. Some popular currency pairs are EUR/ USD, GBP / USD, USD / JPY etc.
BASE AND QUOTE CURRENCY
In the above example of buying USD using INR (Rupees), the USD is the base currency and the INR is the quote currency. So, if currently, USD is selling for Rs.71.3400 then the (ask) quote is shown as USD / INR = 71.3400.
BID AND ASK FOR FOREX
As in the case of trading securities in the exchanges, Bid and Ask prices exist in case of the Forex market as well. The bid price is the price at which the market is willing to buy and Ask (or Offer) price is the price at which the market is willing to sell. The Ask price is slightly higher than the Bid price. The difference between the Bid-Ask price is called the Bid-Ask spread which is the compensation for the market makers.
For example, if the EUR / USD Bid price is 1.1293 and the Ask price is 1.1297 the Bid-Ask spread is 0.0004.
Quotes for all currency pairs are not readily available. In such a case, the quote is derived from the available currency pair quotes.
Consider, you need the quotes for EUR / INR i.e. we need EUR in terms of INR. But, it is not available in the market. The quotes for EUR / USD is 1.1293 1.1297 (Bid and Ask price). The same for USD / INR is 71.3200 71.3400.
Now, we can get USD selling INR and then EUR selling USD.
In case of a buy order:
The USD / INR Ask price is 71.3400. So, Rs. 71.3400 for 1 USD can be procured. But, the Ask price of EUR / USD is 1.1297. So, to get 1 EUR we need $1.1297 USD. To get $1.1297 USD, we need Rs. 71.3400 X 1.1297 = Rs. 80.5928.
So, the Cross Ask Rate for EUR / INR is 80.5928.
Similarly, the Cross Bid Rate (for sell order) for EUR / INR is = 71.3200 X 1.1293 = 80.5417