The currency price of one country becomes stronger 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 broader impact on people and the economy.
For the sake of this article, we will be using the relationship between the euro and the U.S. dollar as our primary example. More specifically, we will be discussing what happens to the economies of the U.S. and Europe if the euro trades markedly higher against the U.S. dollar, with the assumption that $1 will purchase 0.7 euros.
Currency Price Impact on Travelers
If $1 buys 0.7 euros, U.S. citizens may be more reluctant to travel across the pond 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.
In contrast, European travelers would be much more apt to visit the U.S. 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 of Currency Price on Corporations and Equities
Still using our above scenario, the impact it would have on corporations (particularly large multi-nationals) is more complex because these businesses often conduct transactions in a number of different currencies and tend to obtain their raw materials from a 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 from 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 negative impact on overall corporate profits, and therefore on equity valuations in the domestic market. In other words, stock prices may drop due to lower earnings and negative 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 U.S. 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 U.S. and must pay their expenses in euros are likely to suffer from higher costs.
Currency's Impact on Foreign Investment
Europeans (both individuals and corporations) would likely expand their investment in the U.S. based on these assumptions. They would also be better suited to make acquisitions of U.S.-based businesses or real estate. 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 if $1 converted to 0.70 euros.
How Can You Protect Yourself From Currency Moves?
It's important to make currencies work for you. For instance, when planning a trip it's worth checking the most up-to-date currency conversion before booking flights. Also, it is worthwhile for travelers making purchases overseas is to use a credit card. The reason 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.
One of the best moves for business owners operating in the U.S. that source raw materials from Europe can be to stock up on supplies if the price of the euro begins to climb 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
Currency values tend to fluctuate based on several economic factors, all of which impact investors large and small. Individuals, investors and business owners that take exchange rates into account can mitigate financial risks and take advantage of currency movements toward their business or travel expenses.