What is foreign exchange rate policy and how does it affect local businesses? Here is everything an entrepreneur must know about foreign exchange rate. If you are an entrepreneur who is interested in starting a business that will transact business not just in your country but also from clients outside your country, then you need to have a good understanding on how foreign exchange works.
This is important because, if you transact business with international clients either by selling your goods and services to international clients or importing products, services, raw materials or machinery and equipment from abroad, you will require forex.
Table of Content
What is Foreign Exchange?
The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, followed by the credit market.
The main players in this market are the larger international banks. Financial centers around the world function as anchors of trading between a wide range of multiple types of buyers and sellers around the clock, with the exception of weekends.
Since currencies are always traded in pairs, the foreign exchange market does not set a currency’s absolute value but rather determines its relative value by setting the market price of one currency if paid for with another. Ex: US$1 is worth X CAD, or CHF, or JPY, etc.
Please note that the foreign exchange market works through financial institutions and operates on several levels. Behind the scenes, banks turn to a smaller number of financial firms known as “dealers”, who are involved in large quantities of foreign exchange trading.
Most foreign exchange dealers are banks, so this behind-the-scenes market is sometimes called the “interbank market” (although a few insurance companies and other kinds of financial firms are involved). Trades between foreign exchange dealers can be very large, involving hundreds of millions of dollars. Because of the sovereignty issue when involving two currencies, Forex has little (if any) supervisory entity regulating its actions.
The foreign exchange market assists international trade and investments by enabling currency conversion. For example, it permits a business in the United States to import goods from European Union member states, especially Eurozone members, and pay Euros, even though its income is in United States dollars.
It also supports direct speculation and evaluation relative to the value of currencies and the carry trade speculation, based on the differential interest rate between two currencies. As a matter of fact, in a typical foreign exchange transaction, a party purchases some quantity of one currency by paying with some quantity of another currency.
What is Foreign Exchange Rate?
An exchange rate is the number of units of one currency exchangeable for one unit of another. For example, the United States now uses a system of flexible or floating exchange rates and under this system, exchange rates are determined by the demand for and the supply of dollars.
- The demand for dollars is based on other countries’ desires to purchase domestic goods and services and to invest in this country.
- The supply of dollars is based on U.S. citizens’ desires to purchase the goods and services from other countries.
- The equilibrium exchange rate occurs where the quantity of dollars demanded equals the quantity of dollars supplied.
How Foreign Exchange Rate Affects Your Business
Basically, movements in exchange rates alter the international price of goods and services. Please note that if the dollar depreciates (the exchange rate falls), the relative price of domestic goods and services falls while the relative price of foreign goods and services increases.
In this situation, the change in relative prices will increase U.S. exports and decrease its imports. If the dollar appreciates (the exchange rate increases), the relative price of domestic goods and services increases while the relative price of foreign goods and services falls. In this situation, the change in relative prices will decrease U.S. exports and increase its imports.
Consider a computer device priced at $10 in the U.S. that will be exported to Nigeria. Let us assume the exchange rate is N300 naira to the U.S. dollar. Not including the cost for shipping and other transaction costs such as import duty fees and other fees for now, the $10 computer device would cost the Nigerian importer N3,000 naira.
If the dollar were to strengthen against the Nigerian naira to a level of N350 naira (to one U.S. dollar), and assuming that the U.S. exporter does not increase the price of the computer device, its price would increase to N3,500 naira ($10 x 350) for the Nigerian importer.
This may force the Nigerian importer to look for cheaper components from other locations. The 10 percent appreciation in the dollar versus the naira has thus diminished the U.S. exporter’s competitiveness in the Nigerian market.
At the same time, assuming again an exchange rate of N300 naira to one U.S. dollar, consider a cocoa exporter in Nigeria whose primary market is in the U.S. A kilogram of cocoa that the exporter sells for $10 in the U.S. market would result in them receiving N3,000 naira when the export proceeds are received (neglecting shipping and other costs).
If the naira weakens to N350 naira to one U.S. dollar, the exporter can now sell the one kilogram of cocoa for $9.09 to receive the same amount of naira (500). The 10 percent depreciation in the naira versus the dollar has therefore improved the Nigerian exporter’s competitiveness in the U.S. market.
The result of the 10 percent appreciation of the dollar versus the naira has rendered U.S. exports of computer device uncompetitive, but it has made imported Nigerian cocoa cheaper for U.S. consumers. The flip side is that a 10 percent depreciation of the naira has improved the competitiveness of Nigerian cocoa exports, but has made imports of computer device more expensive for Nigerian buyers.
An increase in foreign exchange rate will;
- Reduce your business capacity – you won’t be able to import more products, raw materials and machinery especially if you depend on importations.
- Reduce your profits – the more the goods or raw materials you import at a higher price, the lesser your turn-over and profits.
A reduction in foreign exchange will;
- Increase your business capacity – you will be able to import more products, raw materials and machinery and equipment especially if you depend on importations.
- Increase your profits – the more the goods or raw materials you import at a cheaper price, the higher your turn – over and profits.