How to Interpret Exchange Rates

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Foreign exchange rates specify how much a particular currency is worth in terms of another currency. Like stocks, foreign exchange rates are established by currency traders who buy and sell various foreign currencies on a daily basis. There are a number of exchanges on which foreign currency is traded, and the U.S. foreign exchange market is one of the oldest exchanges in the world. Fluctuations in exchange rates can have a significant impact on a company’s financial performance, so understanding how to interpret exchange rates is important for corporate managers and investors.

Retrieve the exchange rate you are interested in from a website such as XE.com. The home page of XE.com contains a chart showing the exchange rates of major global currencies, or you can search for a particular exchange rate using the converter at the bottom of the page. Suppose you learn that one U.S. dollar is equal to 95 Japanese yen. This exchange rate means that if you were to travel to Japan you could purchase 95 yen with one dollar. Also, if you were to see a good priced at 95 yen, you would know that this price is equal to one dollar.

Convert a specified quantity of one currency into another currency. Set up an equation so that the units of currency you are converting will cancel out. For example, suppose you are planning a trip to Japan and you want to know how many yen you can buy with $350. Using the exchange rate from Step 1, set up the following equation: (350 dollars) x (95 yen / 1 dollar). Because dollars are in both the numerator and denominator of this equation, dollars will cancel out and you will be left with yen. In this example, $350 = 33,250 yen.

Analyze historical trends in exchange rates. You can pull data on historical exchange rates using XE.com. Suppose that six months ago, the yen-dollar exchange rate was $1 = 80 yen vs. a current exchange rate of $1 = 95 yen. In this case, the U.S. dollar has appreciated (i.e. strengthened) relative to the yen because you can now buy more yen with one dollar than you could six months ago. This currency appreciation means that Japanese goods will be cheaper for American consumers, which may encourage Americans to import more Japanese goods and may also encourage more Americans to travel to Japan. Also, businesses that manufacture goods in Japan but sell those goods in the U.S. will benefit, since they can exchange their dollar revenue for more yen.

Tips & Warnings

  • Note that currency depreciation has the opposite effects from those described in Step 3. If the dollar were to depreciate (i.e. weaken) vs. the yen, businesses whose revenue is in dollars but whose costs are in yen would suffer: their costs would remain fixed, but their dollar revenue would be exchanged for fewer yen, which would hurt margins. To maintain fixed margins, these firms would have to cut costs. Many multinational businesses attempt to hedge out exchange rate risk using forward contracts, which allow them to lock in a fixed exchange rate many years in the future. Such contracts reduce downside risk, but they can also have a negative impact on a company depending upon how exchange rates move.

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