IF - Foreign Exchange Rates Lesson

Foreign Exchange Rates

In our global economy, it is hard for a business not to deal in international trade. With this trade comes the issues that accompany dealing in a variety of currencies and exchange rates. Many things can affect exchange rates: a country's economy, its political situation, or even a change in interest rates. View the presentation below to learn how foreign exchange rates work.

Business and Foreign Exchange

With more and more companies participating in global business, an understanding of the risk and rewards inherent in dealing with foreign exchange is important. Companies that have branches in foreign countries as well as those who trade internationally are at the mercy of exchange rate fluctuations. In addition, companies and individual investors will practice foreign exchange speculation which attempts to profit from these same fluctuations.

Currencies change in value against each other all the time. This is because most currencies are based on flexible exchange rates. Currencies change in value because there is a change in demand for holding that currency. Households, governments and businesses need other countries' currencies to buy their goods and services. Currencies can get stronger or appreciate against another currency or they can get weaker or depreciate against another currency. Appreciation makes foreign goods less expensive to the company and imports increase; depreciation makes foreign goods more expensive and exports more attractive.

A change in exchange rates can affect a business in several ways:

• Exchange rates can make products bought abroad either more expensive or less expensive. For example, multinational companies that pay foreign workers in their own currency would pay less in U.S. dollars (before conversion) when the dollar is strong against the foreign currency and would pay more in U.S. dollars (before conversion) when the dollar is weak against foreign currencies.
• The price of raw materials may change. For example, a U.S. company would want to purchase more raw materials from overseas when the U.S. dollar was strong because the goods would be cheaper.
• The price of competitors' products might change in the home market. For example, if the U.S. dollar were weak against the Euro, a California wine producer might see the price of French wines drop in the U.S. marketplace.

Firms have options in managing foreign exchange rates:

1. Monitor exchange rate changes. This is the simplest option and should be used if the firm does not perceive that it is at great risk from exchange rate fluctuations.
2. Lock into exchange rates with a forward contract. That means purchasing the foreign currency now and paying for it sometime in the future. If the currency you are purchasing appreciates, by the time you pay for it, you have saved money.
3. Hedge against exposure to exchange fluctuations by buying derivatives which would be forward contracts in other currencies solely for the investment value. For instance, you might need to buy using the Euro but would also buy forward contracts in the Chinese Yaun and the Japanese Yen because they appear to be appreciating in value. Therefore, if you lose money on the Euro, you will recover that loss with profit from the Yen and Yaun. This is the most complicated option.
4. Manage currency transactions through business practices. This is done in a large part by setting up contracts that allow for a limit on the effect of exchange rates. Another tactic is to only accept payment or pay in your core currency, which eliminates your loss but may be difficult to negotiate.

Trading Foreign Currency

Not only do foreign exchange rates affect business, but they are also a business in and of themselves. The foreign exchange market, called Forex, works just like the stock market, except that you are buying and selling currencies rather than stock. Any lesson on Forex trading begins with learning how to read a Forex quote.

The first currency listed in our quote above, the U.S. dollar, is the base currency. The second currency listed, the Canadian dollar, is the quote currency. In all currency quotes, the base currency is worth one unit, and the quoted currency is the amount of currency that one unit of the base currency can buy.

When buying, the exchange rate tells you how much you have to pay in units of the quote currency to buy one unit of the base currency. In the example above, you have to pay .8023 in US dollars to buy 1 Canadian dollar.

When selling, the exchange rate tells you how many units of the quote currency you get for selling one unit of the base currency. In the example above, you will receive 1.2468 U.S. dollars when you sell 1 Canadian dollar (1/.8023).

So how do speculators make money doing this? The same way stock investors do: buy low-sell high. Here is an example.

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