Exchange rates; a profitable business for banks?
Updated: Feb 1
What are exchange rates?
Each country/zone in the world has a currency that enables its people to exchange goods and services. The value of a given currency versus the currency of another nation is called the “exchange rate”.
There are 2 types of exchange rates:
· Fixed rates: it is when a currency is pegged to another major currency, defined by the government through its central bank and one of its main goal is to bring stability to exporting and importing countries.
· Floating rates: This rate is determined by the private market, mainly by supply and demand, or better said: by the people through every-day trading.
After Richard Nixon ended the Bretton Woods Agreement in 1971 some countries still decided to peg their currency to another major currency such as the US dollar, for example, the oil-net-exporter Saudi Arabia. 1 U.S. dollar will always be $3.75 riyals (or at least until their government decides to float its currency).
However, in the open market, floating rates are moved by on-going trading and are constantly fluctuating. If the US dollar has a high demand, we will see an increase in its value. If there´s a low demand for this currency, its value will decrease.
Factors that impact exchange rates:
There are several factors that can influence exchange rate values, both on a short-term and long-term basis. On one side we have the macroeconomic factors as an example of what could alter the price of a currency in relation to another in the long run, and on the other side, we have daily reasons that make prices go UP or DOWN in a matter of minutes.
SPOT price vs any Exchange Rate
It is called SPOT price to the cash value of a currency, literally meaning: the current price of a dollar in the open market for example. This SPOT price is and will be the reference point for any transaction made with two currencies.
But a reference to what ??
Reference to the price that any bank decides to offer you. Now, we can imagine two different exchange rates for the same currency pair: the SPOT and the bank´s offer. The difference between these two prices is informally called “SPREAD”.
Formally known as the bid-ask spread: the difference between the amount a dealer (your bank) is willing to sell a currency (ask) versus how much the currency trader (you) is willing to buy it (bid).
*climax incoming* the spread is what the banks “charge” for their international transaction service (besides fees and extra costs) and is going directly to their pockets as a commission.
ATTENTION UP NEXT !!
It is common, to only see as a cost the transaction or wire fees, but it must also be considered as a cost the spread banks are offering and at the same time, create more awareness in exchange rates.
Also, there is a key concept usually employed by banks, called the “preferential rate" a psychological ease often used to keep clients happy and unworried. You might have heard of this with your bank and wonder how you could get that “preferential rate”. If you fall in the limbo of not knowing whether you are on that list just follow the next example to calculate your spread.
Spot´s rate vs the bank´s offer and the preferential rate:
Example: Company ABC in Texas has US dollars and needs to buy $500,000 Mexican pesos with his trust-worthy-long-time-relationship bank.
Points to take into consideration:
· With the SPOT price, Company ABC needs $22,222 US dollars
· With the price Bank “X” offers, Company ABC will be needing $22,422 US dollars to buy $500,000 MXN pesos.
· And with the preferential rate the company will be needing $22,321 dollars.
As you can appreciate, Bank X´s offer requires more dollars for the same amount of pesos in the 3 examples. The preferential rate is good (compared to the common rate offer) but is it still good when we compare it to the Spot price? Can it be better?
The spread is not a secret, your bank explains it on its website…
When we are dealing with currencies, we already know that it is a very volatile environment, affecting exchange rates and making it risky for both parties, the seller, or the buyer. The bank will never take this risk so, it is likely that they will acquire the underlying currency at an inferior price that they will offer it to you.
As the market moves, currency exchange rates fluctuate making it difficult to keep or fix a rate, unless you are into the derivates world. Therefore, the bank is constantly adjusting its rates to mitigate its risk. This is done by their sole discretion based upon factors such as market conditions, exchange rates charged by other parties, their desire rate of return, risk, and other business factors. You can read, and it is highly recommended to do so, your bank´s disclaimer in its corresponding foreign exchange section. BE AWARE!