In the old days, if a person wanted to exchange currencies, he had to first convert his currencies into US dollars and then only convert those dollars into the currency of his choice.
For example, if this person wanted to change his sterling for Japanese yen, he would first have to convert his sterling into dollars and then convert it back into yen.
With the invention of interchangeable currencies, or cross currency pairs, individuals can now avoid the process of converting to US dollars by simply and directly exchanging them for the currency of their choice. Some non-exhaustive examples include: GBP/JPY, EUR/JPY, EUR/CHF, and EUR/GBP.
Calculation of currency exchange rates
Warning: this part may seem a little daunting unless you like numbers. It’s not complicated but it may seem a little dry. However, most online brokerage platforms calculate all these exchange rates for you.
If you still like to understand how things work internally, this section is for you. Besides, it’s always interesting to know how things work, isn’t it? In this section, we will show you how to calculate the offer (the “bid” or purchase price) and the request (ask or sale price) for a currency pair.
Suppose we want to find the offer/demand price for the GBP/JPY pair. The first thing we would do would be to look at the price of supply and demand for both the GBP/USD and USD/JPY pairs.
Why these two pairs?
Because these two pairs include the US dollar as the common denominator. These 2 pairs are called the “legs” of the GBP/JPY because they are all associated with the US dollar.
Now suppose we find the following offer/demand prices:
GBP/USD: 1.5630 (bid-offer) / 1.5635 (ask-demand)
USD/JPY: 89.38 (bid-offer) / 89.43 (ask-demand)
To calculate the GBP/JPY bid price, you simply multiply the GBP/USD and USD/JPY bid prices.
If you get 139.70, nice work! Your calculating machine is working perfectly well, well done!
To obtain the GBP/JPY demand (ask) price, simply multiply the GBP/USD and USD/JPY bid prices (bids) to obtain 139.82. Easy! Easy!