4 Exchange Rates and Currency Risk

How exchange rates affect transactions

An exchange rate is the price of one currency in terms of another. It determines how much a buyer or seller must pay when an international transaction involves different currencies. Because rates can change between the agreement and payment, they can affect costs, revenues, profits, and the value of foreign investments.

Exchange-rate systems

Countries use different arrangements to determine the value of their currencies. These arrangements lie along a spectrum rather than falling only into fixed and floating categories.

• Fixed or pegged rate: A government or central bank maintains the currency at a target value or within a narrow range against another currency or a basket of currencies. This can make trade prices more predictable, but defending the peg may require intervention and can limit independent monetary policy.

• Floating rate: Supply and demand in the foreign-exchange market largely determine the rate. A free float involves little intervention. Under a managed float, authorities may buy or sell currencies to influence movements without maintaining a fixed target.

• Intermediate arrangements: Rates may move within bands, follow a gradual adjustment path, or combine a peg with periodic changes.

No system eliminates all risk. A peg can change or come under pressure, while a floating rate can move substantially. The system influences how exchange rates adjust and how much uncertainty businesses face.

Currency quotes and movements

Exchange rates are usually quoted as a currency pair. A quote of $\$1.10$ per euro means that one euro costs $\$1.10$. If the quote rises to $\$1.20$ per euro, the euro has appreciated against the dollar, and the dollar has depreciated against the euro. Appreciation and depreciation are relative to the other currency and depend on how the rate is quoted.

Rates move as the supply of and demand for currencies change. Influences include trade and investment flows, interest-rate expectations, inflation, the economic outlook, and government or central-bank actions.

All else equal, a stronger currency makes foreign goods and services less expensive for domestic buyers, but can make domestic exports more expensive to overseas customers. A weaker currency can have the opposite effects. The effect on actual prices may be incomplete: firms may adjust profit margins, and imported inputs can make exports more costly to produce.

For example, a U.S. importer must pay a European supplier $\text{€}100{,}000$. At $\$1.10$ per euro, the payment costs $\$110{,}000$. If the euro rises to $\$1.20$, the payment costs $\$120{,}000$. The importer’s dollar cost increases by $\$10{,}000$, even though the invoice amount in euros is unchanged.

The FX market and its contracts

The foreign-exchange (FX) market enables businesses, banks, investors, governments, and other participants to exchange currencies. Banks and other dealers connect many customers and trade with one another. Transactions may be arranged directly between parties or through trading platforms; FX trading is largely an over-the-counter market.

Common FX transactions include:

• Spot transactions: Exchange currencies at an agreed rate for near-term settlement.

• Forwards: Agree today to exchange specified amounts of two currencies at a set rate on a future date. Businesses often use forwards to plan the domestic-currency cost or value of a known future payment.

• FX swaps: Exchange currencies now and agree to reverse the exchange later, often to manage short-term currency funding.

• Options: Pay for the right, but not the obligation, to exchange currency at a specified rate under agreed terms.

These contracts can help manage uncertainty, but they have costs and conditions. A hedge may also limit gains if the exchange rate moves in a favorable direction.

Three kinds of currency exposure

Transaction exposure arises when a firm has a foreign-currency payment or receipt due in the future. If a U.S. company owes euros, a rise in the euro increases its dollar cost. If it is due to receive euros, a fall in the euro reduces the dollar value of its revenue. The same currency movement can therefore help one side of a transaction and hurt the other.

Translation exposure arises when foreign subsidiaries’ financial statements are converted into the parent company’s reporting currency. Economic exposure develops over time as changing costs and prices may alter a firm’s competitiveness, sales, and value, even when no specific invoice is awaiting payment.

Managing currency risk

Businesses can match receipts and payments in the same currency, arrange a forward contract for a known payment or receipt, or use an option when they want protection while retaining the possibility of benefiting from favorable movements. A multinational can also coordinate currency flows across subsidiaries.

The appropriate approach depends on the size and timing of exposures, the firm’s ability to absorb losses, and the costs and risks of each hedge. Identifying exposures and choosing suitable operational or financial hedges can reduce uncertainty in international transactions.