Exchange Rates: What They Are And How They Can Impact Your Business (2024)

Key Takeaways

As an international business, you may have ongoing international payments in different currencies flowing into your bank account or may need to pay suppliers in a currency different from your home currency.

Therefore, it is inevitable to understand how one of the most liquid financial markets works and eventually, gain profits through these value fluctuations.

This article will outline everything you need to know about exchange rates, including what they are, why they matter to your business, and how you can make them work for you.

Let’s dive right in.

In essence, an exchange rate is the price of one currency in terms of another. It's like a price tag you see when you're swapping one item for another.

For example, if you're buying products from Chinese suppliers, the price might be listed in Yuan. The exchange rate will help you figure out how much it will cost in your home currency.

Countries don’t necessarily always use their own official currencies.

Sometimes, countries with smaller economies adopt a currency from a larger, more stable economy. This is often done to combat inflation, promote economic stability, and facilitate trade.

Take Ecuador as an example. Instead of using their country’s currency, they prefer to use the U.S. dollar to address hyperinflation and stabilize their economy.

Similarly, France, Germany, Italy, and other European countries adopted the Euro as a common currency to promote economic integration and facilitate trade within the Eurozone.

Exchange rates have a negative impact on your profitability and competitiveness. When the rate fluctuates, they can:

• Impact your costs: If you import goods, a stronger local currency can mean lower costs, while a weaker one can make imports more expensive.
• Affect your revenue: If you sell overseas, a weaker local currency can boost your revenue as your products become cheaper for foreign buyers.
• Change the value of your investments: If you have investments in foreign currencies, exchange rate changes can affect their value in your local currency.

Thus, it is crucial to manage your exposure to these fluctuations to maintain your financial health and remain competitive in the global marketplace.

Exchange rates are often expressed as currency pairs, such as USD/GBP. Each pair has two basic parts:

• Base currency: The currency you are using to purchase another currency (in this example, USD).
• Quote currency: The currency you want to buy (in this example, GBP).

The exchange rate tells you how much of the base currency (USD) is needed to buy one unit of the quoted currency (GBP). Suppose the exchange rate between USD and GBP is 2. It costs GBP 2 to buy USD 1.

There are two methods for quoting the currency - either through direct (in American terms); or indirect (in European terms).

• Direct quote (American terms): This shows the price of one unit of foreign currency in terms of the domestic currency. For example, USD 1.20/EUR means it costs 1.20 US dollars to buy 1 Euro.
• Indirect quote (European terms): This shows the price of one unit of domestic currency in terms of foreign currency. For example, JPY 110/USD means you get 110 Japanese yen for 1 US dollar.

Did you know? Most currencies are quoted against the US dollar because it's the global primary reserve currency, held in large quantities by reserve banks and used in countless international transactions.

A fixed exchange rate is a system where a currency's value is held relatively constant against another currency or a group of currencies. This stability is achieved by central banks actively managing the exchange rate.

For businesses, fixed rates offer predictability. This makes it easier to plan international transactions and forecast costs.

However, there's a trade-off, as it limits a country's ability to independently control its own monetary policy.

Please note that the fixed exchange rates are not truly fixed. They are allowed to fluctuate within a small range.

Floating (or flexible) exchange rates are the opposite. Their value is determined by supply and demand in the FX market, which means it constantly shifts based on forex trading activities.

The floating exchange rate is more commonly used by countries nowadays.

The flexibility allows countries to adjust to changing economic conditions, but it also means more volatility and uncertainty.

Example: Most major currencies, including the US dollar, euro, Japanese yen, and British pound, are floating.

A managed float, sometimes called a “dirty float”, is a hybrid approach that combines elements of both fixed and floating regimes.

Instead of a single fixed point, the central banks set a target range for their currency's value and intervene in the market to keep it within those bounds. This provides some stability while still allowing for flexibility to respond to changing economic conditions.

Example: The Chinese yuan. The People's Bank of China sets a daily reference rate for the yuan against the US dollar and allows limited fluctuations around that rate (typically around 2%).

If your company involves exporting and importing goods from some other overseas countries, chances are you would probably need to pay your trading partners in their nation’s currency or you can receive payments from your customers in another currency.

One quick and simple way is to ask your bank to help you convert the currency into their local capital payments at a spot rate.

But then the problem is traditional banks will charge a lot of different fees which can add up the cost for you.

Alternatively, fintech firms such as neobanks and payment service providers often provide competitive exchange rates and charge lower conversion fees. This can help you and your business save money and improve the bottom line.

One of the biggest concerns for businesses dealing with foreign currencies is that the exchange rates increase or decrease larger than you anticipated.

Let's face it: it can eat into your profits.

Currency hedging is a risk management strategy that can help safeguard your business from unfavorable movements.

Some companies use hedging as a safety net in case of a time gap from payment to receiving the bill from customers.

In other cases, if you have to pay an overseas vendor, you wouldn’t want to have too much swing in exchange rate just so you don’t need to pay extra because of increased exchange rates.

Currency arbitrage is a more complex strategy that takes advantage of small price differences for the same currency in different markets.

For instance, if the euro is priced lower in Hong Kong than in London, a trader could potentially buy euros in Hong Kong and sell them in London, profiting from the price difference.

While it can potentially generate quick profits, arbitrage comes with substantial risks. Success requires expertise, specialized tools, and a deep understanding of market dynamics.

Important: Due to the complexity and risks, businesses interested in arbitrage should consult with financial professionals experienced in this specialized area.