A international exchange rate, also known as a foreign exchange (FX) rate, is the price of one country's currency in terms of another country's currency. Prior to 1971, exchange rates were fixed by an agreement among the world's central banks. Since then, however, currencies have floated, or moved up and down, based on supply and demand.
A number of factors influence exchange rates, including: relative rates of inflation; comparative interest rates; growth of domestic money supply; size and trend of balance of payments; economic growth (as measured by the gross national product); dependency on outside energy sources; central bank intervention; government policy and political stability; and the world's perception of the strength of the foreign currency.
As nations and their economies have become increasingly interdependent, the FX market has emerged as a global focal point. With an estimated daily FX turnover exceeding $1 trillion, this is by far the world's largest market. In order to remain competitive in the world economy, it is vital to manage the risk of adverse currency fluctuations. In recent times, the worldwide trend has been toward the consolidation of markets and currencies, as in the case of the European Economic Union.
The largest users of the FX market are commercial banks, which serve as intermediaries between currency buyers and sellers. Corporations and financial institutions also trade currencies, primarily to safeguard their foreign currency-denominated assets and liabilities against adverse FX rate movement. Banks and fund managers trade currencies to profit from FX rate movements. Individuals also are subject to fluctuating FX rates, most commonly when a traveler exchanges his/her native currency for a foreign one before embarking on a business trip or vacation.
When the Chicago Mercantile Exchange introduced trading in foreign currency futures in 1972, it enabled all currency market participants, including individual investors, to capitalize on FX rate fluctuations without having to make or take delivery of the actual currencies. Foreign currency futures offer risk management and profit opportunities to individual investors, as well as to small firms and large companies.
There are two types of potential users of foreign currency futures: the hedger and the speculator. The hedger seeks to reduce and manage the risk of financial losses that can arise from transacting business in currencies other than one's native currency. Speculators provide risk capital and assume the risk the hedger is seeking to transfer in the hope of making a profit by correctly forecasting future price movement.
The results of companies that operate in more than one nation often must be "translated" from foreign currencies into U.S. dollars. Exchange rate fluctuations make financial forecasting more difficult for these companies and also have a marked effect on unit sales, prices, and costs. For example, assume that current market conditions dictate that one American dollar can be exchanged for 125 Japanese yen. In this business environment, an American auto dealer plans to import a Japanese car with a price of 2.5 million yen, which translates to a price in dollars of $20, 000. If that dealer also incurred $2, 000 in transportation costs and decided to mark up the price of the car by another $3, 000, then the vehicle would sell for $25, 000 and provide the dealer with a profit margin of 12 percent.
But if the exchange rate changed before the deal was made so that one dollar was worth 100 yen—in other words, if the dollar weakened or depreciated compared to the yen—it would have a dramatic effect on the business transaction. The dealer would then have to pay the Japanese manufacturer $25, 000 for the car. Adding in the same costs and mark up, the dealer would have to sell the car for $30, 000, yet would only receive a 10 percent profit margin. The dealer would either have to negotiate a lower price from the Japanese manufacturer or cut his profit margin further to be able to sell the vehicle.
Under this FX scenario, the price of American goods would compare favorably to that of Japanese goods in both domestic and foreign markets. The opposite would be true if the dollar strengthened or appreciated against the yen, so that it would take more yen to buy one dollar. This type of exchange rate change would lower the price of foreign goods in the U.S. market and hurt the sales of U.S. goods both domestically and overseas.
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"It All Depends." The Economist (US), January 30, 1999.
Miller, Kent D., and Jeffrey J. Reuer. "Firm Strategy and Economic Exposure to Foreign Exchange Rate Movements." Journal of International Business Studies. Fall 1998.