The best exchange rate is one that allows entrepreneurs doing business abroad to earn their expected profits. Variations in currency values are the result of factors beyond entrepreneurs’ control, and can significantly impact the profit margin of their transactions. Here are the factors that influence the currency exchange rate, along with some strategies for protecting your business.
Foreign exchange market fluctuations are driven by the decisions of international investors who, at any one time, prefer holding one currency rather than another. Exchange rates basically obey the law of supply and demand, with the latter being shaped by a number of factors, the most important being:
Regional stability and economies
If region A is stable and shows promising growth and region B has a more uncertain economic and political future, investors will prefer holding the currency of region A.
This explains why a tense geopolitical landscape or a major international economic crisis looming on the horizon is often accompanied by a rise in the value of so-called “safe haven” currencies, chief among them the American dollar.
Demand for products
If region A’s products are in high demand in the world, while region B’s are less so, buyers will want to hold more of region A’s currency in order to buy the products they prefer.
This explains the direct correlation between the value of the Canadian dollar and international demand for natural resources: Since these resources account for a large share of Canadian exports, the Canadian dollar tends to become stronger when demand for natural resources rises, and vice versa.
If interest rates in region A are higher than in region B, international investors will prefer making investments in region A’s currency.
This accounts for the appreciation of our currency when interest rates in Canada rise.
If region A’s rate of inflation exceeds region B’s, region A’s currency will drop in value more quickly than region B’s. International investors will therefore prefer holding currency from region B.
Thus, when a country’s inflation increases, the value of its currency generally drops.
How can the future value of a currency be predicted?
Analyzing all these factors is a complex task, as they often evolve counter to one another, and it isn’t easy at all to predict what the overall trend will be. Currency exchange specialists employed by financial institutions try to anticipate currency fluctuations in exactly the same manner that stock market investors attempt to forecast how corporate shares traded on the market will perform. These predictions are sometimes exaggerated or flat-out wrong, and this can lead to sudden market corrections.
Some investors feel that, in the very long term, currency exchange need not be taken into account in their decisions, because all increases and decreases will pretty much even out over time. This is an arguable position that can be taken for a very long-term outlook, such as for an infrastructure investment abroad. However, from the short- or medium-term perspective that is more representative of business transactions, currency variations have an important impact on the profit margins of businesses that buy or sell abroad.
To protect themselves against risks associated with market fluctuations, an entrepreneur engaging in international transactions needs the right tools. Here are three solutions available to businesses:
1. Forward exchange transaction
This is the simplest and most widely used tool. It makes it possible to set the exchange rate for the conversion of a currency in advance, thereby completely eliminating market fluctuation risk.
For example, consider an exporter who is expecting to receive US$500,000 in three months. Because his project costs were established in Canadian dollars, if the U.S. dollar drops in value against the Canadian dollar during those three months, he may see his profits shrink before his eyes. Thanks to a forward exchange contract, he gets to set the currency conversion rate now, and it will apply at the time of conversion three months down the line.
2. Forward exchange range transaction
A forward exchange range transaction also provides protection against unfavourable market fluctuations while offering greater flexibility. Instead of a fixed rate, this approach establishes a safety range comprised of a floor rate and a ceiling rate.
For instance, a contractor could obtain a protection that would guarantee a rate between 1.2500 and 1.3200 for a specific amount and at a specific date. If the markets end up being favourable to the contractor, they will benefit from this transaction up to a certain point; if the opposite is true, they remain protected.
3. Foreign currency option
This tool provides a client with protection in an unfavourable market and offers an unlimited upside should the market prove favourable. It is highly flexible, with several combinations possible. Given the potentially large benefits, an entrepreneur must pay a premium to buy the option.
For example, if an entrepreneur submits a bid in a call for tenders for a construction contract in the United States, a foreign currency option would be an ideal solution. If they are awarded the contract, they will be protected against exchange rate fluctuations. If they do not get the contract or if the market is particularly favourable for their business at the time of the transaction, they are not tied to it. In all cases, the entrepreneur is not liable for paying anything more than the premium amount.
To figure out which strategy is best suited for your situation, it is essential to assess the possible risks. An expert can guide you through the process, from an analysis of the situation to carrying out the exchange transaction.
Currency market fluctuations can have substantial negative repercussions for companies doing business abroad. Thorough understanding and an appropriate exchange risk hedging strategy are critical to success. To be fully protected, discuss your plans for international business development with your advisors before implementing them.
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