Understanding Exchange Rates for Business
Exchange rates have a direct impact on businesses and there are many factors that affect exchange rates. It is therefore essential to gain a good understanding of these factors to help mitigate possible risks and develop a successful FX plan for your business.
What affects exchange rates?
Exchange rates are relative; they are manipulated by governments as a measure of economic control, and they are related to the trading relationship between two countries.
There are 8 factors that can impact exchange rates:
- Rates of inflation or deflation
- Monetary policies
- Fiscal policies
- Political and economic conditions
- Commodity prices, especially oil
- Interest rates
- Unemployment rates
Inflation and Interest
Inflation rates can affect exchange rates. As a country’s inflation rate rises, the currency rate typically drops; if a country’s currency rate is lower than their trading partners, it can affect the price of goods and services that are exported and imported. The reverse is also true; a lower inflation rate can be followed by an increase in the country’s currency rate value, which would mean that exported goods would cost more with trading partners, while imported goods would cost less.
Every element of the economy is connected, and what affects one element often affects the other. Interest rates can impact exchange rates and inflation. Central banks manipulate interest rates to help balance inflation and exchange rates to stop a country from extreme fluctuations that can have a negative effect on a country’s economy. Higher interest rates provide lenders with a higher return, which typically attracts foreign capital and causes a higher exchange rate. Lower interest rates often cause lenders to move their capital to a country with a higher interest rate, which can cause the value of the currency to fall.
Monetary policy is the process that the central bank or currency board uses to control the supply of money, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency. A country’s monetary policy typically determines the actions of the banks. The policy includes modifying interest rates, buying and selling government bonds, and changing the amount of money banks are required to keep in reserve. Behind all falling and rising inflation and interest rates, there is a monetary policy guiding those rates.
If a country’s GDP is strong, the value of its currency tends to rise, and the opposite is also true; a weak GDP can cause the currency to be worth less. If the demand for the product(s) exceeds the supply, the exchange rate typically rises in value. For instance, reports that the US expanded 1.0% in Q3 (and not the 0.6% that was forecast) immediately boosted the US dollar, benefiting people that planned to exchange US dollars for other currencies.
When government spending or taxes are used to grow or slow down the economy, it often affects the exchange through income changes, price changes, and interest rates.
Political and economic conditions
If a country is unstable politically, it can indicate the beginning of problems with imports and exports, and can cause investors to lose confidence in the currency. This can result in investors moving their investments out of a country. Political turmoil can also impact trade, which impacts currency values.
Commodity prices, especially oil
Economic growth and exports are frequently the direct result of a country’s domestic industry. Generally, a country will keep their exchange rate lower if they want to encourage the export of domestic product. Oil is a key commodity and as it rises and falls it can impact all other commodities and, subsequently, currency rates.
If unemployment figures are high or rising, the Central Bank usually does not want to increase interest rates. In fact, they may cut interest rates to relieve the extra financial difficulties that a high unemployment rate has on the economy.
You can mitigate your risk with fluctuating exchange rates by following these steps:
Find out what the current exchange rate is and compare the rates and fees offered by banks and other providers. You can manage foreign exchange risk by setting a budget for the year. You will need to provide your Currency Specialist with details such as, the number of trades and possible time frame of each transaction.
Consolidating foreign currency transactions will help determine the financial position of an operation and can be included in financial statements. Currency fluctuations should be included because this exposes the gains and losses made.
How to protect against changing exchange rates
To help protect your financial exchanges there are a few steps you can take to mitigate the risk of fluctuating rates. Building a foreign exchange strategy will help determine which type of transaction agreement works best for your business. Spot orders, market orders and forward contracts can work together as part of an integrated strategy.