Where Do Exchange Rates Come From?

The exchange rates come from the spot FX market, also known as just “spot FX”.

In the spot FX market, “spot trades”, also known as “spot transactions” occur between institutional traders known as “FX dealers“.

What is being traded exactly in the spot FX market?

Contracts. Specifically, foreign exchange (FX) spot contracts.

FX spot contracts stipulate an actual physical exchange of the underlying currencies at a specific exchange rate.

It’s important to point out that you are NOT trading the underlying currencies themselves.

But you are trading a contract involving the physical exchange of the underlying currencies.

In the spot FX market, an FX dealer buys or sells a contract to physically exchange one currency for another currency.

This means that a spot trade is a binding obligation to buy or sell a certain amount of foreign currency at an agreed-upon price  (or exchange rate).

So if you were to buy EUR/USD on the spot FX market, you are trading a contract that specifies that you will receive a specific amount of euros in exchange for U.S dollars at an agreed-upon price.

Spot Rate

This agreed-upon price is known as the “spot rate”.

This price is determined at the point of trade.

And the physical exchange of the currency pair takes place right at the point of trade or “on the spot”.  (Although in reality, most transactions usually take 2 days to settle.)

The spot rate also referred to as the “spot price.”

The spot price is the current “market price” (exchange rate) of a currency pair.

The tricky thing to be aware of is that there is no single “market price” for a currency pair.

That’s because the FX market is decentralized.

Think of the spot FX market as going to a bazaar.

Let’s say you want to buy a rug and there are 10 different merchants selling this rug.

You visit each merchant at their booths and ask what their selling price for the rug is. Each will quote you its own “spot price” independent of each other (assuming they don’t overhear your conversation with other merchants).

After you’ve asked around, you’ll pick the rug merchant who gave you the best price. This is your “spot price” for the rug.

FX dealers may quote different spot rates to different market participants. The “spot price” is found by asking a bunch of different FX  dealers at the same time. So the spot rate is really a matter of “how many people you ask”.

It is from these spot rates that your forex broker (hopefully) uses as a reference when it displays its prices on its trading platform for you to trade on.

We say “hopefully” because as a retail forex trader, it’s important to know that you are NOT trading in the spot FX market.

Physical Settlement

A spot trade involves physical settlement, meaning if you bought EUR/USD, you’d have to fulfill the contract and physically deliver U.S. dollars and accept delivery of euros.

This would be great if you were like a European manufacturer who exports goods to the U.S. or maybe a wealthy American tourist who is about to go on holiday in Europe for the summer, but we assume you’re neither.

The concept of spot FX trading is similar to that of futures trading, in which the trader is buying and selling agreements to make or take delivery of an underlying asset at a specified time in the future. But the time frames are much different. Whereas spot FX is delivered within a few days, futures are delivered months later.

As retail forex traders, we’re not interested in actually taking possession of actual foreign currencies, all we care about is what happens to the exchange rate of EUR/USD.

Remember, we are simply making bets on (and trying to profit from) the movement of exchange rates of currency pairs.

So the exchange rate (“price”) you want to make bets on (“trade”) is assumed to be based on the “spot rates” made from “spot trades” in the “spot FX market”, but as a retail forex trader, you are NOT trading in the “spot FX market” yourself.

If you’re not making spot trades, WHAT exactly are you trading then?

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