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Wednesday, February 16, 2011

On how FX quotes work for real

Students get frustrated when they attempt to go from the book to the real world.

Finance textbooks tend to use fraction notations for a direct quotation like USD/JPY = 0.0120 to imply the number of USD to buy 1 JPY. It takes less than a little over a penny to buy a yen.

Students are then faced with quotes from financial websites where USD/JPY=83.4250 to imply that it takes more than 83 yen to buy one US dollar.

The trading logic is as follows
The currency listed first in the pair is referred to as the base currency. The second one is called quote or trade currency. This means the trader currently holds the base (USD) and he or she is using it to buy the quote currency (JPY). After looking at the quote the trader knows she will get 83.425 yens for every 1 dollar she trades.

The following chart explains it all.

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