Understanding Foreign Exchange Rates and Currency Risk
An exchange rate is, simply, the price of one nation’s currency in terms of another currency, often termed the reference currency. There are two kinds of exchange rate transactions: spot and forward. A spot rate is the price at which currencies are traded for immediate delivery (delivery two days later). A forward rate is the price at which foreign exchange is quoted for delivery at a specified future date. When a currency increases in value, it experiences appreciation. When it falls in value and is worth fewer U.S. dollars, it undergoes depreciation.
The foreign exchange market, where currencies are traded, is not a physical place; rather, it is an electronically linked network of banks, foreign exchange brokers, and dealers whose function is to bring together buyers and sellers of foreign exchange.
Supply and Demand in Foreign Exchange
The demand for currency is derived from the demand for a country’s exports and from speculators looking to make a profit on changes in currency values. For example, American demand for Eurozone goods and services and euro-denominated financial assets. Eurozone prices are set in euros, so in order for Americans to pay for their Eurozone purchases, they must first exchange their dollars for euros. That is, they will demand euros.
The supply of currency is determined by the domestic demand for imports from abroad. Similarly, the supply of euros is based on Eurozone demand for U.S. goods and services and dollar-denominated financial assets. In order for Eurozone residents to pay for their U.S. purchases, they must first acquire dollars. The increased Eurozone demand for U.S. goods will cause an increase in the Eurozone demand for dollars and, hence, an increase in the amount of euros supplied.
The equilibrium exchange rate is the rate which equates demand and supply for a particular currency against another currency. Factors that influence supply and demand in the long run are inflation rates, interest rates, economic growth, and political and economic risks. Exchange rates are also crucially affected in the short run by expectations of future currency changes, which depend on forecasts of future economic and political conditions.
In conclusion, foreign exchange (FX) is important because it affects the price of domestically produced goods sold abroad and the cost of foreign goods bought domestically. The healthier the economy is, the stronger the currency is likely to be.
Hedging and Currency Risk Management
Hedge/hedging: To enter into a forward contract in order to protect the home currency value of foreign-currency-denominated assets or liabilities.
- Forward market hedge: A company that is long a foreign currency will sell the foreign currency forward, whereas a company that is short a foreign currency will buy the currency forward. In this way, the company can fix the dollar value of future foreign currency cash flow.
- Money market hedge: The use of simultaneous borrowing and lending transactions in two different currencies to lock in the home currency value of a foreign currency transaction.
- Exposure Netting: A method of hedging currency risk by offsetting exposure in one currency with exposure in the same or another currency. It has the objective of reducing a company’s vulnerability to exchange rate risk. It is especially applicable in the case of a large company, whose various currency exposures can be managed as a single portfolio; it is often challenging and costly to hedge each and every currency risk of a client individually when dealing with many international clients. A firm’s exposure netting strategy depends on a number of factors, including the currencies and amounts involved in its payments and receipts, the corporate policy with regard to hedging currency risk, and the potential correlations between the different currencies to which it has exposure.
- Risk shifting: The transfer of risk from one party to a transaction to another party to that same transaction.
- Currency risk sharing: An agreement to share currency risk between international sellers and buyers to spread out the impact of currency rate changes. The agreement may specify how to split the loss when currency rates are unfavorable and how to split the gain when currency rates are favorable. It eliminates the zero-sum game nature of currency fluctuations, in which one party benefits at the expense of the other (For instance, a seller in the US may agree with the buyer in Japan that they divide the gains or losses that may result in the change of currency equally between them).