Understanding exchange rate

Laura Oliva Financial risk management guide, Fx

Doing business throughout the world is not the same from one country to another. Trading in different languages, culture and time zone complicates the activities.

One of the key factors of global business is the use of multiple currencies. Exchange rate (a.k.a. FX) is the relative value of a currency compared to the currency of another country. It is a value that depends on the trading relationships between the countries and is determined by supply and demand of currencies. Exchange rates play a vital role in a firm’s  life. Their fluctuations can seriously impact its balance sheet. FX movements affect the amount of cash inflows received from exporting and the amount of cash outflows needed to pay for imports. FXs are probably the most watched and analyzed economic variables. Nevertheless, generating a quality forecast of exchange rates is hardly an easy task.

Even if prediction is difficult, it is crucial to understand what drives currency values in the medium-long term. The following discussion provides an overview of the key factors for under- standing how exchange rates are determined.

1. POLITICAL AND ECONOMIC CONDITIONS

Economies are linked by international trade and capital flows. Country economic conditions such as growth performance, balance of payments, trade deficit, impact a currency’s value.

1.1 import/export

If one country’s exports rises by a greater rate than that of its imports, this results in rising revenues from exports, which provides increased demand for the country’s currency and an increase in the currency’s value (appreciation).

Otherwise if the price of exports rises by a smaller rate than that of its imports, the value of the currency will dampen in relation to its trading partners (depreciation).
If a country faces trade deficit with import exceeding exports, it needs foreign investors to finance the difference.

FX import export.001

1.2 Flows of investiments

Foreign investors favor countries with good investment climate in which to invest their capital.
A country with positive performance will lead to capital inflows from other countries perceived to have more political and economic risk. Unstable political system can cause a loss of confidence in a currency and a flow of capital to the currencies of more stable countries.

The effect of differences in economic performance is indeterminate. When one country grows faster than the others, it tends to need more imports to sustain its growth.
Growth should increase demand for foreign currency if exports growth at a lower rate than imports.

A rising trade surplus will increase the demand for a country’s currency by foreigners, so that there should be a pressure for appreciation. A trade deficit should weaken the currency.

1.3 Domestic demand

Weak economic growth and poor employment conditions can hold back investment and consumer spending, driving down the value of a nation’s currency.
But sometimes the reverse is true. A depreciating currency can stimulate exports, which can help employment, driving up consumption and investments.

1.4 Political system

On the political side, anything that provides uncertainty is going to have an effect on the currency, usually in a negative manner, as tensions and political turbulence make a country’s currency an unattractive investment opportunity. For example, since the Ukraine crisis, the ruble has depreciated by over 50%.

The bottom line is that a strong economic and political environment is more likely to appeal to investments from foreign investors. In order to invest in the desired country, they have to purchase the country’s currency – pushing up its demand – that typically appreciates.

Monetary policy

2. MONETARY POLICY

The central banks increase or decrease the benchmark interest rate – or the cost of borrowing currency – for a number of reasons, such as protecting against inflation or deflation, and more generally, maintaining a growing and healthy economy.

If a country suddenly decides to shift to a more expansionary monetary policy, there are two main effects:
• the real interest rates will drop;
• inflation will accelerate.

Both consequences lead to a depreciation of the currency. Otherwise, a restrictive monetary policy lead to an appreciation of the currency.
For example, recently (November 2014), the Japanese yen de- preciated against all major foreign currencies, after the Bank of Japan expanded its asset-buying program.

USD YEN

3. INTEREST RATES

Interest rates are the main driving force behind a currency’s valuation. Financial investments are attracted by high expected return.
If investors expect real interest rates for a certain country to increase, they are going to buy financial assets: higher interest rates can stimulate foreign investors to purchase bonds and interest rate-linked financial instruments, like deposits. As consequence, the demand for the country’s currency appreciates.

The opposite relationship holds for decreasing interest rates: lower interest rates tend to depreciate exchange rates.

Interest rate differential between countries reflect differences in economic growth, monetary policy and fiscal policy.

That is true for “normal” interest rate levels. But if interest rates skyrocket, due for example to trouble with public debt, this typically increases currency instability: foreign investors could stop investing and withdraw their money, causing the exchange rates to quickly depreciate.

4. INFLATION RATES

A high rate of inflation will lead to a depreciation of the currency, the purchasing power declines.
If inflation is rising, the central bank is going to want to control that, usually through raising interest rates.

But it is also true that those countries with very high inflation typically see depreciation in their currency in relation to the currencies of their trading partners.

5. PUBLIC DEBT

Usually investors prefer to hold low amounts of risky assets. A large public debt may be worrisome to foreigners if they start believing that country may default on its obligations is a tangible risk.
Thus, they will sell bonds denominated in that currency if the risk of default is great.
Low risk currencies are more highly valued than high risk currency.

Why currency appreciates?

6. CONCLUSION

Understanding international financial markets is crucial not only for the largest multinational corporations but also for other firms that conduct international business.
Even smaller firms usually generate part of their sales in foreign markets.

When financial managers develop budget forecasts for their firms, they should recognize the potential impact of exchange rate determinants on cash flows. As these determinants affect exchange rates, affect the present value of future cash flows to be received or to be paid.

Given the complexity of a multi-currency environment, it is most useful to start by monitoring operations in order to determine how the firm is exposed to exchange rate fluctuations so to decide whether and how to protect the company from that exposure.

Authors: Laura Oliva and Raffaele Zenti

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About the Author

Laura Oliva

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Co-founder of eKuota. Degree in Corporate Finance from the Universita’ Luigi Bocconi in Milan, she has more than a decade of experience in capital markets. She was Head of Debt Capital Markets within the Allianz Group, she worked at a number of international investment banks. She was Global Product Specialist, Head of Structured Finance and ABS team, Head of Syndication and Credit Analyst. She managed and executed bond issues and loans syndication for major italian companies. She is a Fixed income and Securitization expert, she deals with financial analysis and financial markets. Co-Author of the AdviseOnly blog. Mom of three, born in Rimini now she lives happily in Milan.

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