International trade, travel and finance all depend upon exchanging one currency for another. Everyday, via an array of systems and institutions, countries transfer trillions of dollars via the exchange of currencies.

Thus, conversations regarding currency exchange typically involve two different exchange rates: the Forex (foreign exchange) exchange rate and the bank exchange rate; though different in purpose as well as method of use, to the untrained eye, they may appear to provide the same service.

Overview of Currency Exchange Systems

The Forex (foreign exchange) exchange rate is determined by the worldwide forex market, which is open for trading currency continuously throughout the world. Bank exchange rates are set to assist banks with their retail individual or commercial customers.

There are differences between these two currency exchange systems primarily in the way that they price currencies, how their respective customers access the base currency prices and the degree of transparency associated with each of their respective exchange systems.

Role of Global Financial Institutions

The Reserve Bank of India, internationally, along with the International Monetary Fund (IMF), as well as a number of other organizations play an important role in determining how these currency exchange systems would function.

An understanding of the basic differences between these two types of currency exchange rates is important in understanding how currency is valued as it relates to real world transactions.

Understanding the Forex Exchange Rate

The forex exchange rate is the value of one currency relative to another currency within the global forex market, which is also referred to as the forex marketplace. The forex market is comprised of a decentralized marketplace that is open 24 hours per day, 7 days per week, in most countries (including New York City, Tokyo and London).

Foreign currency exchange rates are typically based on their supply and demand. In addition to being based on supply and demand, the relative strength of the economies of two unrelated countries will have an effect on the relative value of their respective currencies; however, other issues (such as political stability, current interest rates, or the overall state of the financial markets) can influence the strength of currency between the same two countries.

Forex Market Participants

Central banks, multinational corporations, hedge funds, and retail traders are all part of this “forex” market–where currencies are traded on a counter-cyclical basis. Diversity in these types of participants provides liquidity and allows for real-time pricing, thus making forex exchange rates volatile and reflective of current market activity.

Types of Participants

Central Banks: These institutions strive to maintain the stability of their currency and will intervene when necessary to help achieve these goals.
Financial Institutions: Facilitate large currency trades.
Retail Traders: Buy and sell currencies using online trading platforms.

Real Time Pricing

Forex rates change continuously because trading is done 24 hours a day in the forex market. Additionally, because forex rates can and do change rapidly (within seconds), forex rates are very responsive to both global events and market sentiment versus the more stable nature of bank exchange rates.

Understanding Bank Exchange Rates

Bank exchange rates are the rates charged by banks and financial institutions to customers when they buy or sell foreign currencies. Bank exchange rates are also typically used for many everyday transactions.

Common Applications

International travel
Remittances

Unlike forex rates, bank exchange rates are often not market-driven; therefore, they generally have a markup (or margin) added to them to account for banks’ operating costs, risks and profits. This last applies to both the selling price and the buying price of bank exchange rates.

Price Structure in Banks

When commercial banks calculate the rate that they will charge customers for buying or selling foreign currency, they reference the spot foreign exchange (forex) rate and allocate additional charges.

Comparison between Forex and Bank Exchange Rates

Two fundamental aspects differentiate forex rates from bank rates: how the rates are established by market forces and how the rates apply to the user. Forex rates are based solely on market supply and demand pressures while the rates used by banks include an internal margin cost for the banks.

Key Differences

Forex trading occurs on a continuous basis from Sunday to Friday while bank rates have set intervals when the banks can modify their rates.
Forex rates are typically associated with trading institutions and forex traders whereas bank exchange rates are associated with retail consumers.

In summary, the difference between the two types of rates demonstrates the overall role of each type of rate in the global financial ecosystem. Forex focus on improving the efficiency of the market while bank exchange rates focus on providing access and customer service to retail consumers.

Access and Transparency

Forex exchange rates are easy to access through trading venues and financial news written about forex trading throughout the world. Forex rates can be accessed by anyone who owns a computer or smart device; however, one would need to register with a trading venue to trade forex.

In contrast, bank exchange rates are generally not transparent in that the banks typically make a profit (markup) on the foreign exchange rate and the customers are not informed of the bank's exchange rate margins; therefore, customers only see the final bank exchange rate charged to them.

Nonetheless, banking customers often prefer using banks to make regular payments because of the convenience, customer service availability and consumer protection provided by banks, although these banking services typically have fees that exceed the fees charged by forex trading.

Factors that Affect Forex Exchange Rates

Forex exchange rates are influenced by numerous worldwide economic and financial conditions, constantly changing (in real-time) around the world. This is primarily due to the forex market's ability to reflect new economic and political information worldwide.

The most common economic indicators that influence currencies throughout the world include, inflation, employment and GDP.

Interest Rates and Central Banks

In addition, interest rate changes made by central banks will also have a large impact on currency valuation and price movements. For example, when a U.S. Federal Reserve, Reserve Bank of India or other central bank alters their primary rates, this would shift the flow of money between the countries.

When one country increases earnings potential, all factors being equal, the demand for that country will rise.

Economic Reports and Market Impact

Reports that provide macro-economic data/indicators are among the most monitored by traders and institutions around the globally. Reports that provide information about changes in inflation, trade balances and industrial production levels can cause immediate price movements in currencies.

Even slight changes from previous estimates can create volatility in exchange rates.

Geopolitical Events

In addition to macro-economic data, events such as geopolitical tensions, elections and trade agreements will also affect the forex market and maintain volatility. If two countries experience increased geopolitical tension and investors are less confident about those countries as an investment, then the currencies of those two countries will decrease in value.

Sentiment and Speculation

Market sentiment can be defined as how the cumulative choices of all investors who are trading forex will affect the value of the currencies based on the current and anticipated conditions which exist for the trade. The cumulative effect of all related and unrealized market expectations can create a significant amount of short-term volatility in the prices of different currencies.

Speculation creates a greater amount of volatility in currency price movements than can be produced by quantifiable economic information or market expectations. Professional traders regularly engage in speculative trading to generate profits from realizable price movements.

Bank Exchange Rate Mechanism

Exchange rates established by banks are impacted by both the overall economic conditions of the financial market and the pricing policies of the individual banks. Some examples of banks using systematic methods to develop their currency pricing policies are Axis Bank and ICICI Bank.

The bank exchange rate changes infrequently compared to the foreign exchange market. Banks typically change their exchange rates periodically based upon their operating costs, risk for operating, and their regulatory environment.

Cost Components in Bank Pricing

Transaction processing and administrative costs
Costs for user name and password protection when handling and transporting currency
A cushion for large fluctuations in the value of a currency

By building these costs onto the base foreign exchange rates taken from the foreign exchange market, banks create a markup over the base foreign exchange rate. As a result of this markup, customers are usually charged slightly less than the rates at which institutions trade currencies in the global financial market.

Regulatory Framework and Compliance

The Reserve Bank of India regulates the foreign exchange market and requires all banks in India to follow a set of guidelines while conducting foreign exchange transaction activity. These regulations allow all banks to have an equal degree of transparency, accountability, and financial stability.

The regulations set forth by the Reserve Bank of India, along with those created by the Bank for International Settlements and other international financial organizations, help banks manage their exposure to risks.

Role of International Financial Institutions

Organizations such as the International Monetary Fund (IMF) and World Bank offer assistance to member countries when it comes to managing their foreign exchange policy and for global monetary stability.

These organizations also offer assistance, policy guidance, and capital resources in an effort to create a uniform and consistent determination of each country's respective currency value throughout the global foreign exchange market and ensure consistency and transparency between commercial banks and between currencies.

Conclusion

The difference between bank exchange rates and foreign exchange market exchange rates demonstrates how the global economy functions. Forex exchange rates are found in a very dynamic and decentralized marketplace; therefore, rates will change with changes in demand and supply of each specific currency in real-time.

Conversely, bank exchange rates are determined by the foreign exchange market and are made based on what it would cost to do business as a bank and how bank's profit margins affect the ability to do business in foreign currencies.

This highlights the various levels of participation in the currency market by the different end users. Large banks and traders typically transact utilizing the forex market's exchange rate, while retail end-users typically use banks to access transactions in a regulated and accessible manner.

Organizations like the Bank for International Settlements and regulatory organizations work in conjunction with each other to ensure that both systems operate smoothly and efficiently and within controlled environments.

Difference Between Forex Exchange Rate and Bank Exchange Rate