Question

What is the exchange rate? How are exchange rates determined, and what is the best tool for understanding exchange rate fluctuations? Why are exchange rates important for international business?

Answer 1

• An international exchange rate, also known as a foreign exchange (FX) rate, is the price of one country's currency in terms of another country's currency. Foreign exchange rates are relative and are expressed as the value of one currency compared to another.
• If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and is determined by the market forces of supply and demand. Exchange rates for such currencies are likely to change almost constantly as quoted on financial markets, mainly by banks, around the world.
• The purchasing power parity (PPP) is perhaps the most popular method.The PPP forecasting approach is based off of the theoretical Law of One Price, which states that identical goods in different countries should have identical prices.For example, this law argues that a pencil in Canada should be the same price as a pencil in the U.S. after taking into account the exchange rate and excluding transaction and shipping costs. In other words, there should be no arbitrage opportunity for someone to buy pencils cheap in one country and sell them in another for a profit. Based on this underlying principle, the PPP approach forecasts that the exchange rate will change to offset price changes due to inflation. For example, suppose that prices in the U.S. are expected to increase by 4% over the next year while prices in Canada are expected to rise by only 2%. The inflation differential between the two countries is: 4% - 2% = 2% .

  This means that prices in the U.S. are expected to rise faster relative to prices in Canada. In this situation, the purchasing power parity approach would forecast that the U.S. dollar would have to depreciate by approximately 2% to keep prices between both countries relatively equal. So, if the current exchange rate was 90 cents U.S. per one Canadian dollar, then the PPP would forecast an exchange rate of: (1 + 0.02) x (US$0.90 per CA$1) = US$0.918 per CA$1. Meaning it would now take 91.8 cents U.S. to buy one Canadian dollar.

• Exchange rates play a vital role in a country's level of trade, which is critical to most every free market economy in the world. The important aspects of exchange rates on international business are :

1. If the business buys any products from another country. The cost of those products will change if the exchange rate changes.
2. If the business sells any products to a foreign country. The sale price (and therefore profits) will change if the exchange rate changes.
3. If the business has borrowed money from, or lent money to, someone in a foreign country. The amount to be repaid, and the interest amount, will change if the interest rate changes.

That was the direct impact. There is also an indirect impact. No business is an island - it depends upon other businesses which might be affected by exchange rates. For example, a UK business which neither sells nor buys nor borrows from another country. However, it uses trucks to move it's products around the country. If the foreign exchange rate changes, the cost of the fuel those trucks use changes (because it is imported from abroad) and that affects the costs of the business.