How Foreign Exchange (FX) Works
Foreign Currency Exchange
The FX rate a provider will quote you a rate based off what is called the inter-bank rate. This rate is set by the 10 largest banks and smaller banks take their rates from one of these ten. This rate then filters down to other providers and, based on their size, they will all trade at different margins off the inter-bank rate.
There are different rates for selling and for buying currency to and from an FX provider. The difference between the buy and sell rates is called the ‘spread.’ Due to the high volume of currencies exchanged worldwide (and a large number of providers servicing different client bases) the spreads can range from very small to quite large.
As an example, if the inter-bank rate on a conversion of GBP 100,000 from GBP to AUD was 2.500:1 (ignoring any transaction fees) and using an example spread of .0200, a foreign exchange provider would earn as follows:
FX Providers Rate: GBPAUD 2.50 x 100,000 = AUD 250,000
Clients Rate: GBPAUD 2.48 x 100,000 = AUD 248,000
The profit that the FX provider would make on this particular deal is 200 pips (each 0.0001 is called a ‘pip’) or AUD 2,000.
In this case the client would receive AUD 248,000 in return for GBP 100,000.