What Is an International Currency Exchange Rate?
An international currency exchange rate is the rate at which two currencies can be exchanged. International currency exchange rates display how much of one unit of a currency can be exchanged for another currency.
Understanding an International Currency Exchange Rate
The international currency exchange rate is the amount of money in one currency that can be received for one unit of another currency. For example, USD/JPY 113.54 means that an individual or business will receive 113.54 Japanese yen (JPY) for every US dollar (USD). Put another way, one USD buys 113.54 yen.
Currency exchange rates can be floating, in which case they change continually based on a multitude of factors. Or, they can be pegged or fixed to other currencies, in which case they move in tandem with the currencies to which they are pegged.
The international currency exchange rate is an important determinant of the health of an economy, and is one of the most-watched and analyzed macro factor on a global scale. The rates affect global commerce, businesses that operate across borders, and individuals who are traveling or trading.
Factors that Affect International Currency Exchange Rates
There are multiple factors that affect the value of an international currency exchange rate. One factor is an increase or decrease in interest rates in a country. When a country increases its interest rates, foreign investment flows in to capture the higher yields that will be gained from investments, such as government bonds.
An increase in demand for a country’s investments would lead to an increase in demand for the country’s currency. When currency demand goes up, the exchange rate is strengthened. The stronger exchange rate is reflected in a decline of the other currency in the pair. For example, if interest rates in Japan go up more than US rates, the US dollar will likely (but not always) decline in value to reflect the increase in the JPY. In this case, the USD/JPY rate would decline. If the USD strengthens against the JPY, the USD/JPY rate would increase.
Another factor that could affect the international currency exchange rate is the implementation of an expansionary monetary policy whereby the money supply in an economy is increased (or decreased). All else equal, an increase in the money supply will lead to more of the domestic currency chasing the same quantity of goods and services. This results in an increase in the price of these goods, and hence, inflation. When inflation increases, the value of the domestic currency decreases. A contraction of the money supply decreases supply and could help increase the value of a currency.
Exchange Rates and Cross Border Business
The Financial Accounting Standards Board (FASB) and Generally Accepted Accounting Principles (GAAP) require companies that operate in multiple countries to translate the foreign currencies to US dollars on their financial statements. The currency conversion will translate to either gains or losses, depending on the international currency exchange rate between the US dollar and the foreign country’s currency.
For example, a Canadian retail importer decides to purchase some merchandise from the US when the international currency exchange rate is USD/CAD 1.25. The value of the merchandise is USD100,000 which translates to CAD125,000. They don't have to pay right now though. They order the goods and can pay later.
The retailer, factoring in all other casts, decides to sell the merchandise in Canada for CAD143,750, representing a 15% markup. However, when the Canadian retailer actually goes to pay for the goods, the international currency exchange rate is USD/CAD 1.35 which means that the Canadian dollar has depreciated in value, and the US100,000 worth of goods now costs the retailer CAD135,000.
To profit from the same markup, the retailer will have to sell their merchandise for CAD155,250. Given that this may be a costly alternative, they may decide to reduce the markup or negotiate a better rate with the US manufacturer.
International Exchange Rates Affect Investments
Knowing the value of one currency in relation to different foreign currencies helps investors to analyze investments priced in foreign currency. For a US investor, knowing the dollar to euro exchange rate is important when choosing European investments. The return on the investment is not only determined by the gain or loss on the actual investment, but also the varying exchange rate over time.
If an investor buys an investment in another currency, and that currency rises. That will improve the performance of the underlying asset. If the currency they buy the asset in falls, that will mean worse performance relative to the asset. The following example shows how.
Example of How International Exchange Rates Affect Investments
Assume an investor in the US buys a Canadian stock for CAD10. They buy 100 shares, worth CAD1,000. The exchange rate for the USD/CAD is 1.2050 at the time of purchase. This means it costs the investor US829.88 (CAD1,000 / 1.2050) to buy the CAD1,000 investment.
Over the course of a year, the stock appreciates to CAD12, representing a 20% gain. The US investor sells and now has CAD1,200 they need to convert back to US dollars.
The total gain or loss will depend on the exchange rate when they covert their money back to US dollars. They bought when the USD/CAD was 1.2050. To make more than 20% the investor wants the Canadian dollar to have appreciated versus the US dollar. If the CAD has dropped in value relative to the US, then they will make less than 20% on their investment.
Assume the rate is now 1.28. The USD has appreciated because it now costs more CAD to buy one USD. The CAD1,200 is worth US937.50 (CAD1,200 / 1.28). The investor has made money, but not 20%. They have only made 12.97% ((US$937.50 - US$829.88) / US$829.88). The loss on the currency ate up some of the profit they made on the investment.
Now assume the rate went the other way, and the CAD appreciated, resulting in a USD/CAD rate of 1.16. CAD1,200 is now worth US1034.48 (CAD1,200 / 1.16). This represents a total gain of 24.65% on the investment (US1034.48 - US829.88 / US829.88).
The exchange rate can cause big swings in total returns, especially over long periods of time.