The currency price of one country gets stronger and/or weaker against another country's currency on a daily basis, but what exactly does that mean for those who don't trade in the forex market? Currency exchange rates affect travel, exports, imports and the economy. In this article, we'll discuss the nature of currency exchange and its effect on people and the economy.

Before delving into the topic in more detail, we must first establish a constant; for demonstration purposes we will be talking about the relationship between the euro and the U.S. dollar. More specifically, we will be talking about what happens to the U.S. economy and to the economies of Europe if the euro trades markedly higher against the U.S. dollar. The assumption we will be making is that US$1 will purchase 0.7 euros.

The Impact on Travelers
If US$1 buys 0.7 euros, U.S. citizens will be more reluctant to travel across the pond. That's because everything from food to souvenirs would be more expensive - about 43% more expensive than if the two currencies were trading at parity. This is an illustration of the effect of the purchasing power parity (PPP) theory.

However, under these conditions European travelers would be much more apt to visit the United States for both business and pleasure. American businesses and governments (via taxes) in the areas that European tourists visit will prosper - even if just for a season.

The Impact on Corporations and Equities
The impact that this scenario would have on corporations (particularly large multi-nationals) is a little more complex because these businesses often conduct transactions in a number of different currencies and tend to obtain their raw materials from a wide variety of sources. That said, U.S.-based companies that generate the majority of their revenue in the U.S. (but that source their raw materials from Europe) would likely see their margins take a hit on higher costs.

Similar pain would be felt by U.S. companies that must pay their employees in euros. By definition, these decreased margins would likely have an adverse impact on overall corporate profits, and therefore on equity valuations in the domestic market. In other words, stock prices may drop due to these lower earnings and forecasts for future profit potential.

On the flipside, U.S. companies that have a hefty overseas presence and draw in a significant amount of revenue in euros (as opposed to dollars), but pay their employees and other expenses in U.S. dollars could actually fare quite well.

European companies that generate the lion's share of their revenue in euros, but also source their materials or employees from the United States as part of their business, would likely see margin expansion as their costs and currency decrease. By definition, this could lead to higher corporate profits and equity valuations in some overseas stock markets. However, European companies that garner a significant amount of their revenue from the United States and must pay their expenses in euros are likely to suffer.

The Impact on Foreign Investment
Under these assumptions, it is likely that Europeans (both individuals and corporations) would expand their investment in the United States. They would also be better suited to make acquisitions of U.S.-based businesses and/or real estate. In fact, this has happened at several points in the past. For example, when the Japanese yen traded at record highs against the dollar back in the 1980s, Japanese firms made significant purchases of real estate - including the world-renowned Rockefeller Center.

Conversely, U.S. corporations would be less apt to acquire a European company or European real estate under US$1 for 0.70 euros scenario.

How Can You Protect Yourself from Currency Moves?
When planning a trip, check the most up-to-date currency conversion before you book your vacations so you can plan your choice of locations appropriately. (There are many ways of finding out local currency rates, including looking in the business section of your local newspaper, checking with a travel agency or searching the internet.) Incidentally, one of the best tips for travelers making purchases overseas is to use a credit card. The reason behind that is that credit card companies tend to negotiate the best rates and the most favorable conversions because they do such a high volume of transactions. These companies take out all the guess work for you, paving the way for smoother (and probably less expensive) transactions.

For small and large business owners operating in the U.S. that source some of their raw materials from Europe, one of the best moves can be to stock certain supplies if the price of the euro starts to climb rapidly against the dollar. Conversely, if the euro starts falling against the dollar, it may make sense to keep inventory at a minimum in the hope that the euro will decline enough for the company to save on its purchased goods.

The Bottom Line
Over time, currency values can vary quite dramatically. However, individuals, investors and business owners can take steps to mitigate risks and take advantage of such currency movements.

Related Articles
  1. Personal Finance

    The World's Strangest Currencies

    Here's a rundown of some of the stranger things people have used as currency over time.
  2. Economics

    A Primer On Reserve Currencies

    For nearly a century, the U.S. dollar has served as the world's premier reserve currency, but the future is uncertain.
  3. Forex Education

    Top 8 Most Tradable Currencies

    Currencies can provide diversification for a portfolio that's in a rut. Find out which ones you need to know.
  4. Forex Education

    An Introduction To Complementary Currencies

    There are alternatives to national currencies. Discover complementary currencies and how they work.
  5. Forex Education

    How Gold Affects Currencies

    There is a strong correlation between gold's value and the strength of currencies trading on foreign exchanges.
  6. Forex Education

    5 Failed Currencies And Why They Crashed

    We look at currencies that were once widely used but are now defunct.
  7. Forex Education

    The New World Of Emerging Market Currencies

    Take advantage of foreign currency markets without stepping out of your house.
  8. Forex Education

    Popular Forex Currencies

    Learn about the most traded currencies and the strategies used to trade them.
  9. Economics

    Understanding Free Trade

    Free trade exists when nations can swap goods and services without the constraints of tariffs, duties or quotas.
  10. Forex Strategies

    Two Great Currencies To Profit From Oil Volatility

    U.S. dollar crosses with Canadian and Australian dollars offer easy access to crude oil trends due to their tight correlation with energy futures.
RELATED TERMS
  1. Trade Credit

    An agreement where a customer can purchase goods on account (without ...
  2. Brazil, Russia, India And China ...

    An acronym for the economies of Brazil, Russia, India and China ...
  3. Optimal Currency Area

    The geographic area in which a single currency would create the ...
  4. European Sovereign Debt Crisis

    A period of time in which several European countries faced the ...
  5. Transfer Risk

    The risk that a local currency cannot be converted into the currency ...
  6. Welfare Capitalism

    Definition of welfare capitalism.
RELATED FAQS
  1. Does M1 include foreign currency?

    M1 may refer to currency in either domestic or in foreign lands. Each country has its own definition of what M1 consists ... Read Full Answer >>
  2. What is the difference between GDP and GDP accounting for PPP (purchasing power parity)?

    The standard measure of gross domestic product, or GDP, is absolute. In contrast, some accounts of GDP are adjusted for relative ... Read Full Answer >>
  3. What are the goals of covered interest arbitrage?

    The goals of covered interest arbitrage include enabling investors to trade volatile currency pairs without risk as well ... Read Full Answer >>
  4. What is the difference between a greenfield investment and a regular investment?

    A greenfield investment is a particular type of investment where an international company begins a new operation in a foreign ... Read Full Answer >>
  5. What are the benefits for a company investing in a greenfield investment?

    Advantages of greenfield investments include increased control, the ability to form marketing partnerships and the avoidance ... Read Full Answer >>
  6. Why did China designated certain territories as special administrative regions?

    The primary reason for the People's Republic of China designating two territories as special administrative regions, or SARs, ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!