What are Exchange Rates?
Has your business ever managed a financial transaction to buy foreign supplies or sell products overseas? In a globalized world, doing business can often entail finding new suppliers, customers and partners outside national boundaries to innovate and be more competitive. When conducting cross-border business operations, companies usually purchase or sell goods and services that are priced in a different currency than that used at home. The value of your local currency compared to a foreign currency is determined by their exchange rate. An exchange rate refers to the monetary value of one currency per one unit of another currency. Exchange rates are expressed in currency pairs that can indicate, for example, how many U.S. dollars can be exchanged for one euro. Knowing the exchange rates involved in your business transaction is necessary to understand your full costs, revenues and profits.
Types of exchange rates
Broadly speaking, exchange rates can be “fixed” or “flexible”. Fixed exchange rates peg the local currency to another currency or asset for determining the value. Fixed exchange rates remain the same over time and they do not fluctuate with the market. By contrast, flexible exchange rates change constantly and are determined by the foreign exchange market and what transactors are willing to pay. Other types of exchange rates include the spot, forward and dual rates. The spot rate is the current price of one currency against another with the shortest delivery time. Forward rates are used for contracts to agree on foreign exchange transactions in the future before the spot rate can be known (see the guide on international commercial contracts for more information on trade contracts). Dual rates occur if an economy has both a fixed and flexible, or floating, exchange rate. There are also situations where the official fixed exchange rate is different from the unofficial rate given that ultimately an exchange rate is the amount agreed between two transactors of one currency for another.
How can exchange rates affect my business?
Exchange rates are constantly in flux. This means your foreign purchases and sales can have a different cost or value than expected when converted into your local currency, affecting your profits. Note that in addition to the quoted rates for a transaction there may be a fixed charge or a percentage fee. For example, if you intend to make a lot of small sales across borders some payment services charge a flat per transaction rate, some of which currently amount to $24 per transaction. This level of costs renders small sales impossible.
Exchange rates have a direct impact on the goods and services you buy, or sell, overseas. For example, if the currency your foreign supplier uses increases its value with respect to your local currency, your supplies from overseas become more expensive. You need to decide what currency your products will be offered for sale in. Many e-commerce platforms offer products with a sales price converted into the currency the buyer is located in, others offer sales in the major traded currencies such as Euro, USD or RMB. You should examine in detail the terms, conditions, charges and rates calculations to see which suit your business activities best.
In addition, exchange rates can have indirect effects on your business operations. For instance, a reduction of your local currency value with respect to the foreign currency in which oil imports are priced can increase transportation, packaging, power and fertiliser costs. On the other hand, foreign sales made in your currency become cheaper and more competitive when the currency of your targeted markets increases its value with respect to your local currency.
What can I do to protect my business from exchange rate risks?
- Monitor exchange rates: International organizations such as the International Monetary Fund (IMF) and the Bank for International Settlements (BIS) offer free-of-charge dashboards that track daily updates on exchange rates between the U.S. dollar and some currencies around the world. For more information, see BIS’s Statistics Warehouse and IMF’s Exchange Rates Wizard. Exchange rate converters such as x-rates.com and com can also help you to get started with foreign exchange calculations for your businesses.
- Hedge exchange rate risks: Financial institutions offer forward contracts that enable businesses to hedge foreign exchange risks by setting an agreement on the exchange rate applicable for a specified payment date in the future. Using forward contracts can be suitable if you want to avoid fluctuations in the exchange rate affecting your foreign business transactions. While you are protected from negative currency movements, you also will not benefit from exchange rates that may turn favorable to your business. Other instruments such as foreign exchange orders or derivatives can be an option if you are open to the possibility of benefiting from positive exchange rate movements but willing to take the risks of losing from unfavorable exchange rates. American Express and Toptal offer more information on hedging strategies.
- Forward transactions: If you are trading out of a country with highly volatile exchange rates relative to your intended sales markets then you could try to fix your input costs exchange rates and your export market exchange rates at the same time through a forward transaction with a financing institution. There is a cost for this service calculated on the basis of the time to the actual transaction due dates and the financing institution’s forecast of what the actual rate will be at that time.
- Alternative solutions: Other options that can help your business mitigate foreign exchange risks include setting up multi-currency accounts or agreeing contracts denominated in your local currency. You can also consult the websites of the central bank, export associations and chambers of industry and commerce in your country to identify additional resources for formulating a financial risk mitigation strategy that best suits your business conditions.
Links to Supporting Information
Trade4MSMEs guide International Commercial Contracts
International Monetary Fund Exchange Rate Report Wizard
American Express American Express Information on Hedging Strategies