Although it is apparent that operating in the foreign exchange market can be profitable, there are considerable risk factors involved in the market. Despite this, businesses continue to exchange billions of dollars in transactions throughout a given day. These transactions are conducted for various purposes, including, but not limited to, the importation and exportation of goods and purchasing services. However, the main concern is the risk factors involved when conducting business through the foreign exchange market. Is the foreign exchange market a risky venture or does the possibility of earning additional profit from the currency exchange cause this risk? However, the hazard involved must not be considerably extreme. If so, industries would not continue to operate and conduct business overseas. They would not allow goods to be produced and manufactured on foreign land as these items must then be transported across the globe. Thus said, the foreign exchange market must be examined to analyze the dangers and profitability involved to understand why some companies prefer to conduct trade in distant countries.
Going to Market
When the word, ‘market’, is used most people consider the mall, grocery store, or flea market. However, the true definition of market is the “act of transactions, buying and selling the visible and invisible interactions of supply and demand” (Clark & Ghosh, 2004). In order to interact in a market, one does not have to be present as transactions can be conducted through technological advances such as the internet or the telephone. Consequently, these transactions can occur internationally with the trade of goods, services, imports, and exports. However, to produce international trade, one must participate in what is known as the foreign market exchange. The foreign market exchange is “the lubricant that enables companies based in countries that use different currencies to trade with each other” (Hill, 2007, p. 313). Since the United States utilizes the dollar as its currency and China utilizes the Yuan as its form of currency, it would be difficult for America to pay China in dollar bills as the dollar holds no monetary value there. Thus, America must convert the dollar into Yuan to reimburse China. Therefore, the market of foreign exchange is, “a market for converting the currency of one country into that of another country” (Hill, 2011, p. 312). Without this market form, trade would prove to be difficult if not impossible between companies, manufactures, and banks around the globe. The foreign exchange market is an imperative and dominating factor when conducting business on an international scale.
Many companies around the world participate in the foreign exchange market as they conduct business in various parts of the world. These companies include Caterpillar, Ford, Apple Computers, and Toshiba. However, it is important to understand why and how such industries conduct business overseas. Many produce business in other countries due to economic resources and to save on manufacturing cost, as “they can hire workers at very low wages (such as 30 cents an hour in China)” (Schlafly, 2007). Other reasons for overseas business transactions are the issues of tariff, trade, and taxations. For instance, “if the company exports its products to the U.S. (or other countries), the foreign government rebates (forgives) the tax” (Schlafly,2007). Many countries illuminate additional fees if an industry moves its manufacturing plants to their country or export and import goods to its port. This policy invites interest for companies and large business to take their factories outside of their home land. Furthermore, many businesses are not required to abide by the laws and policies of the United States government concerning issues such as pollution, employee minimum wage, and benefits. With these money saving factors at hand, many American companies prefer to employ citizens of Singapore, Japan, Taiwan, or Mexico to produce and manufacture goods.
The Foreign Exchange Rate
The main feature of the foreign exchange market is what is known as the foreign exchange rate. The foreign exchange rate is what “allows us to compare the relative prices of goods and services in different countries” (Hill, 2011, p. 312). However, this is ultimately defined as the rate in which one currency is changed into another. The dollar and the Yuan can be used as an example. As of November 2011, the U.S-dollar foreign-exchange rate in late New York on Friday was 0.1575 Yuan for every U.S $1.00, while the Mexican peso is quoted at 0.0741 for every U.S $1.00, (Exchange Rates, 2011). However, the foreign exchange rate for the United Kingdom’s pound is £1.6034 for ever U.S $1.00 and the European euro is €1.3792 for every U.S $1.00. This indicates, that if one were to vacation in Mexico and needed to participate in the foreign exchange market and the bank teller is given $100, the tourist would receive 1349.52 pesos. If this same tourist were to then travel to France, the same $100 would then be converted into €72.50. Therefore, it is important to be aware of the foreign exchange rate when traveling outside of the country and/or conducting business. Since the foreign exchange rate is flexible and always changing, the foreign exchange rate plays a significant influence when conducting business transactions and maintaining profitability.
The foreign exchange rate is not a number that is simply made up by governmental agencies and economist. The exchange rate is determined by the relationship between two currencies and their supply and demand. As a result, “the value of a currency is determined by the interaction between the demand and supply of that currency relative to the demand and supply of other currencies” (Hill, 2007, p.313). This indicates that the exchange rate is ever moving, increasing and decreasing as the supply and demand of currency changes along with interest rates and economic instabilities.
Every hour and every day, the value of a currency will appreciate or depreciate. “An increase in this exchange rate from, say, $1.80 to say, $1.83, is a depreciation of the dollar. The exchange rate between the Japanese yen and the U.S. dollar is … an increase in this exchange rate from, say, ¥108 to ¥110 is an appreciation of the dollar” (Frankel, 2008). This consistent alteration of the foreign exchange rate and its relationship between two currencies can cause concern for businesses and their profitability. For example, on Tuesday it may cost Apple computer’s $16.69 or ¥1500(YEN) at the exchange rate of 1/89.86 to manufacture 45,000 microchips. On Friday the exchange rate would then change to 1/94.42 in which it would then cost Apple computer $15.88 to manufacture the same 45,000 microchips for ¥1500. Apple would then gain a profit of $0.81 because of the change in foreign exchange rate. Although $0.81 is a small fraction, when put on a larger scale of 4.5 billion microchips for 1.5 million yen, Apple would then gain a profit of $8,100 due to the fluctuating exchange rate. However, this ever moving exchange rate can have an adverse effect on a company causing an industry to lose money instead of make money.
Industries involvement in the foreign exchange market can be complex. Many industries participate in the foreign exchange market either “for payment or income” (Hill, 2011, p. 314). This was previously addressed concerning businesses movement of factories and plants to an overseas market. Such was seen in the example with Apple computers and purchase of microchips in Japan. To purchase the microchips, Apple computers had to exchange one currency into the form of another to pay for merchandise. In addition, a company placed overseas may have to pay employees, goods, and bills in addition to services provided. However, the foreign exchange market is not limited to only businesses, companies, and industries. Investors and individuals may all participate in the foreign exchange market as well.
Both individuals and industries utilize the foreign exchange market for various reasons, however, the common denominator is always to exchange from one currency to another. When companies are taken out of the equation, there are only a few ways in which individuals would utilize the foreign exchange market. The primary source for individuals is “to pay for products or services” (Hill, 2011, p. 313). Initially when considering this, the first option is for tourism. For an American to vacation in Italy he must convert his dollar into euro. This way, during his vacation the tourist can spend freely on souvenirs, hotels, restaurants, and various items. Another avenue in which an individual as well as stockholders would utilize the foreign exchange market is when participating in foreign investments.
An appropriate example of foreign investments is when an investor intends to purchase stock overseas. This can be observed in an investor who wants to buy a European stock in Volkswagen vehicles. He will convert $10,000 into pounds, in which his $10,000 would then become £5,000 (when the dollar foreign exchange rate is 2/1). A year later his £5,000 pounds has earned a profit of £1,000. The investor, satisfied, would then cash in on his investment, converting his now £6,000 into $12,000. However, another option must be considered. What if the exchange rate has dramatically changed after a year’s time? Consider if the foreign exchange rate for euro/dollar has now changed from 2.25/1. Then the investor has earned an additional profit of $2,500 because of the currency’s appreciation. In total from an initial $10,000 investment the stockholder has now gained $14,500 from both his initial investment and the change in euro to dollar foreign exchange rate. If the financier made his investment on the “speculation” or belief that the euro will appreciate against the dollar than he has earned his profit through currency speculation. Currency speculation is defined as, “the short term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates” (Hill, 2011, p.314).
Arbitrage can also make it possible for individuals and investors to profit from the foreign exchange market. Although arbitrage is difficult to spot in the market and last for a short period of time, its primary function is to turn a quick profit. Through arbitrage one can produce a profit “from the difference in buying and selling price” (Clarke & Ghosh, 2004). Let’s consider the dollar/rubles exchange rate. If a dollar is worth $1.13 in South Ossetia and $1.19 in Russia an investor can buy a dollar in South Ossetia and sell in Russia and make a profit of $.06. However, if an investor increases his steak and purchases $20,000 at the rate of $1.13 and turn around and sale it in Russia at a higher rate, the investor would gain a profit of $1,200. Although this phenomenon does and can happen, the price difference is only momentary. Through the act of supply and demand, the exchange rate of the dollar versus the ruble would eventually break even as others would see this price variation and take advantage of it. The process of arbitrage would then create an equilibrium of supply and demand of the currency causing the rubles/dollar value to then become equal.
Due to the foreign exchange market’s fluctuation of the foreign exchange rate, there are considerable risk involved in terms of loss and profitability. A foreign exchange risk is simply, “a potential gain or loss that occurs as a result of an exchange rate change” (Giddy & Dufey, 1995). It is important to understand that the risk involved in the foreign exchange market is constant and continuous. Exchange rates are always and forever changing. This can be either hazardous or helpful to any company across the world that deals with international trade. An example is that of Cuba. An American investor may put stock into Cuban banks with the expectation that its currency will rise to that of the dollar. Instead, Cuban currency depreciates causing profit loss of the initial investment. Thus, “a gain of a few moments or less can be long enough to see what was thought to be a profitable transaction changed to a costly loss”, ( Giddy & Dufey, 1995).
As a currency may depreciate in value a company’s profit may decrease depending on which direction a currency is converted. In the year 2000, an American car lot paid Volkswagen $500,000 to build 250 cars. The owner expected to receive a net profit of $7,000 for every car sold on his lot at the foreign exchange rate of €1.00/$1.25. However, a week later the currency depreciated in value causing the foreign exchange rate to fluctuate dramatically to €1.00/$1.40. This fluctuation caused the owner’s profit margin to drop considerably, to $3,000 for every car sold. If the dollar value continued to decrease against the euro, to say €1.00/$1.50 the owner would then be in the red and would owe Volkswagen additional money to manufacture vehicles that the owner already paid for. To prevent such incidents from occurring due to shift in exchange rates, there are several factors in place to illuminate financial risks from occurring for owners, investors, and manufactures.
There are various avenues a company can take to ensure themselves against a potential loss due to a change in the foreign exchange rate. These include forward exchange and currency swap. A currency swap is self-defined. It allows two industries to simply swap or change the currency involved for a short period of time as not to risk profits or earning power due to a fluctuating foreign exchange rate. When taking on a currency swap agreement, both parties would “establishing an interest rate, an agreed upon amount and a common maturity date for the exchange” (“investopedia.com”). This way both industries would refrain from potential risks due to an ever changing foreign exchange rate. Arrangements such as these are referred to as hedging and insurance.
Another insurance against profit loss is what is known as “forward exchange”. Forward exchange is a method of setting a foreign exchange rate for a future date. These dates are usually as early as 30 days or as long as 6 months in the future. By entering a forward exchange contract, companies can ensure that, despite a fluctuation exchange rate the company can sustain a reasonable margin of profitability. If an exchange rate were to fluctuation considerably, companies and manufactures would be entitled to maintain the forward exchange rate agreed upon. For example, according to the Wall Street Journal on the Friday closing date in New York, the foreign exchange for the Australian dollar is that 0.9837 per US dollar. The forward exchange rate 1 month from now is 0.9798; and 0.9663 6 months from now. Thus the foreign exchange market is expecting a depreciation of the Australian dollar against that of the American dollar. Either way, by utilizing forward exchange rates, an industry can insure itself against profit loss and maintain a fair contract when dealing with overseas productivity and importation of goods. Due to this guaranteed insurance, forward exchange rates are very popular amongst businesses. This can be observed as, “in 2007 forward exchange and forward exchange rates accounted for 69% of all forward exchange transactions”(Hill, 2011).
Strategies and Tactics
The hazards involved when utilizing the foreign exchange market can greatly affect business earnings and net worth. Changes in the foreign exchange rate can transform both the translation and economic exposure of the industry. Hence, a company’s financial statements, or translation exposure, can change from month to month. Although Apple Computers may have received a 20% increase of product purchases due to foreign exchange rates, this additional profit may not produce revenue because of the depreciation of the dollar or the appreciation of the yen. Economic exposure, though, has a larger impact on an industry’s revenue potential. This is known as “the extent to which changes in exchange rates affect a firm’s future international earning power” (Hill, 2011). It is what most companies review when considering future profit margins and must be managed to ensure growth and earning potential. If industries were to properly maintain their economic and translation exposure they could considerably minimize risks factors of the foreign exchange market. This can be done by utilizing various hedging tactics and strategies previously discussed, including currency swaps, forward exchange agreements and conducting business in countries with freely convertible currency.
With thousands of businesses participating world trade, the foreign exchange market is vital part of global economy. Without the exchange market, avenues to pay overseas market would be limited. As the economy continues to fluctuation around the world, such as the current falling value of the Euro, the foreign exchange market continues to be a risk as exchange rates shift alongside interest rates and the supply and demand of currency. Despite the various hazards involved, the foreign exchange market serves to be a profitable venue. However, to ensure profit, revenue, and income, companies must utilize knowledge, know-how, and useful approaches when working in the foreign exchange market. This means managing economic exposure, maintain in house foreign exchange markets and predicting future foreign exchange rates to “minimize foreign exchange exposure” (Hill, 2011).
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