Exchange Rates – How they are set up and calculated

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Exchange Rates – How they are set up and calculated

In order to understand how a currency exchange operation sets up and calculates its exchange rates each day, it is important to understand the basics of the business.

First of all, currency exchange offices are focused purely on buying and selling currency; they buy one currency and sell another. In tourist areas, in particular, currency exchange offices will spend most of their day ‘buying’ various different types of foreign currency and ‘selling’ the local currency, since the majority of its customers will be people arriving in the city with their own currency who then need to have some local cash to use. (The exception is the local customer that wants to exchange his or her own local currency for foreign currency; in such a situation, currency exchange offices are able to offer a very good ‘sell’ rate since they will generally be holding a lot more foreign currency than the local currency that they need – so, just as in any other business, when there is an excess of a product, the price will be significantly discounted).

Since the number of transactions relating to the ‘buy’ of foreign currency generally far exceed the ‘buy’ of local currency, at the end of each day the currency exchange office has to sell the foreign currency that it has bought to its own bank, in order to ensure that it has enough local currency to use the next day. The exchange rate that its own bank uses in order to calculate its sale of the local currency to the exchange bureau is the starting point for the calculation of the rate that the bureau will use for the following day’s trading.

The buy and sell rates of each currency exchange office are updated every workday, and are based on the rate that the office has been given by its own commercial bank when selling it the local currency (as above) – note, however, that this is not always the same as the local National Bank rate, although any significant changes of that rate would obviously have some effect. Once the rate is calculated, and since the foreign exchange company needs to make some sort of profit on each transaction, it will usually add a small margin and then add a fee/commission, in order to come to the final calculation.

There are some exchange companies that prefer to state their rates and charge no actual fee/commission, but, at the end of the day, this will have very little effect on the amount of the final transaction since they will always include a much high rate in their exchange calculation in order to cover operating costs and profit.

Currency exchange offices are often criticised for not giving the same exchange rate for a currency that is listed in the paper or online; there are simple and standard reasons for this that are no different to any other retail business. First, as mentioned before, the currency exchange office is in business itself, and it needs to make some sort of profit on each transaction in order to pay its own costs for its own operation – and these are always going to be higher, the more ‘convenient’ the currency exchange office is for the customer (location and time). Second, whilst the exchange rate may be lower than that published, the average amounts exchanged are usually relatively small, which means that the difference in the amount given to the customer is also very small. Currency exchange offices are always, therefore, happy to offer better rates on larger transactions (often better than the published rate) and/or, in some cases, a buy-back guarantee. Third, there are many currency exchange offices (Interchange is one of them) that rewards its loyal customers or those making larger transactions with better rates and other offers such as VIP cards and online transactions.

At the end of the day, currency exchange offices are no different to any other retail business. They want to give a good product at a reasonable price, their prices go down when the amounts purchased are higher and they want to reward their loyal customers as that is how they build their business. However, and unfortunately, just as with any other retail business, they are not able to sell their currency for the same amount as they have bought it as, on that basis, they would very soon go out of business!