Directional shifts in currency exchange rates could allow one to hedge against or even profit from those shifts.
In a global economy, currency plays a pivotal role in the way transactions are structured.
From investment banking to corporate management, currency is involved in nearly all international financial decisions.
As the global economy becomes more complex, currency issues will continue to evolve.
Currency Exchange Rates
With the advantages of selling to the world come the challenges of managing global finance.
Currency plays a prominent role in the way businesses conduct their business and to whom they sell.
Financial managers must develop currency strategies to manage their receivables and payables.
For example, if the US dollar drops against the Malaysian Ringgit, it could hurt a Malaysian exporting company whose receivables are denominated in US dollar.
If the Malaysian Ringgit increases in value against the US dollar, it could raise the Malaysian foreign owned company's manufacturing costs and perhaps cause management to consider moving its manufacturing facilities abroad.
Shifts in currency exchange rates can affect how much a company ultimately earns; therefore, a solid understanding of currency will allow management to craft an effective strategy to address unexpected shifts.
Determining the Exchange Rate
The exchange rate of any currency is its price.
It indicates how much of one currency is needed to buy one unit of another currency.
Suppose it takes 1 US dollar to purchase MR 3.50. The value of 1 US dollar would be MR 3.50.
The value of 1 MR in US dollars therefore would be 0.2857 US dollar (1 US dollar/ MR 3.50).
How is this value determined?
What causes that 1 US dollar to equal MR 3.50 and 1 MR to equal 0.2857 US dollar?
Currency is no different from anything that is bought or sold, and therefore, economic principles determine its price.
A currency price is based on the price at which demand for that currency equals supply of that currency. This is known as the equilibrium exchange rate.
Changes in supply and demand affect the exchange rate.
Currency Supply and Demand Curve:
The supply curve for the currency is upward-sloping. The supply of the currency increases when the value of the currency is strong.
The demand curve for the currency is downward-sloping. The buyers tend to demand more of something when its price is lower.
For example, Americans would be more likely to exchange their dollars for yen when the value of the yen is lower. This enables American consumers and corporations to buy more Japanese products at lower price.
When the value of yen is higher, demand for yen will be lower as Americans are less likely to exchange their dollars for yen as Japanese products are now more expensive.
Factors That Affect Currency Exchange Rates
The following factors have a direct impact on exchange rates.
If the US experiences higher inflation relative to Japan, U.S. goods become more costly than Japanese goods.
As a result, American consumers will demand Japanese substitutes.
This will increase the demand for Japanese yen needed to purchase Japanese products.
At the same time, the supply of yen for sale probably will decrease as Japanese holders of yen are less likely to buy American products, which are now more expensive.
The increased demand for yen and the decreased supply of yen will push the price of yen higher.
If U.S. interest rates rise relative to Japanese interest rates, the supply of yen for sale will increase as more holders of yen will want to purchase dollars to earn more interest in dollars.
As a result, the value of yen will decrease.
Furthermore, the demand for yen should decrease because investors would rather deposit their money in American banks and therefore will demand dollars more than yen.
The decrease in demand combined with the increase in supply will cause a drop in the value of yen as a result of rising interest rates in the United States.
If income levels in the United States increase while income levels in Japan remain unchanged, demand for Japanese goods should increase along with yen.
The shift in relative income is not likely to affect the supply of yen as a change in U.S. income levels will do little to incentivize Japanese yen holders to exchange more yen for dollars.
The increase in demand therefore should raise the exchange rate as American consumers probably will buy more Japanese products overall.
Speculators can cause dramatic movements in currency prices.
They may base their trades on economic predictions or in some cases on expectations of what other high-volume traders will do next.
As more market participants move in tandem, currency values are often driven less by economic fundamentals and more by momentum traders.
By imposing trade barriers and foreign exchange barriers, governments can affect currency values indirectly.
They do this by making it more difficult for foreign businesses to engage in import and export activity, which in turn will affect supply and demand for currency.
At the same time, a government can buy or sell its country's currency, which will affect its supply and ultimately its value.
Government policy changes, however, may not achieve the desired outcome when it pertains to currency .... or anything else for that matter.
Interaction of Factors
Any combination of these factors can affect currency in unpredictable ways.
If you could predict precisely how a combination of factors will affect currency values, you would be busy trading currency from your private island!