Learn About Protecting Your Currency Exchange


What Is a Currency Exchange?

A currency exchange is when you are changing one currency for another. Let us review some examples of when you might want to exchange currency:

  1. I am travelling to a country with a different currency.
  2. I sell my products to people in a country with a different currency.
  3. My family lives in another country with a different currency than which I get paid.
  4. I purchase raw materials, supplies, or inventory from a country with a different currency.
  5. I am attending a school in a country with a different currency.
  6. I own assets or have loans in a country with a different currency, and I make regular payments.

The process seems simple enough, I need to trade my currency for theirs, right?

Currency Exchange

Well, not exactly, there is what is called an exchange rate that determines the trade.

Currency Exchange Rates

Several market participants can determine the exchange rate:

  • Banks
  • Governments
  • Traders
  • You!

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Why Are These Transfers Important?

Currency transfers are important because we live in a global economy. Whenever you buy something that was made in another country, there is a currency exchange at some point. If you sell things to people in other countries, there is a currency exchange. You may have sent a gift to a friend or visited somewhere that required a currency exchange. Let us look at how important these exchanges are:

Data from World Bank

According to the World Trade Organization (1), exports account for more than 25% of the world economy (GDP) and is clearly growing. This means that currency exchanging is growing at a rapid pace and tools need to be implemented to manage risks.

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Why Is It Important to Protect Against Exchange Rate Changes?

Exchange rates change every second of every day. An example: You may have purchased a bottle of French Champagne for New Years 2012 for $30. Due to exchange rates, that price has changed:

Champagne

December 31, 2011
Price = $30

Champagne

July 15, 2012
Price = $27.30
(Yea!)

Champagne

Tomorrow
Price = ???

So from December to July, the price changed in my favor, that is good, right?

If you are importing things, the exchange rate has helped you by about 9%, however, if you export things to France the opposite is true. Lets say you export jets to France and the December 31, 2011 price was $20,000,000

plane

December 31, 2011
Price = $20,000,000

plane

July 15, 2012
Price = $21,800,000

plane

Tomorrow
Price = ???

Great! I just made an extra $1,800,000 on each plane I sold! I’m loving it!

Not so fast, your plane costs the buyer $1,800,000 more (9% increase), so she is likely to buy it from your competitor. If that competitor is from France, the price has not changed for them, so you just lost a sale.

So who should be popping the bubbly when the exchange rate moves? The people buying from the importer? The people buying from the exporter? When the exchange rate moves, one side gains, and the other loses. That is always true unless you have a method to protect yourself from the movements.

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How Can I Protect Myself?

Exchange rates can move a lot in short time span. It really depends on a lot of factors including the type of government, market psychology, interest rates, and fundamentally what people believe the value of one currency is to another.

As an individual, there are a few methods to protect yourself against exchange rate fluctuations. This is what a professional means when they “hedge” a risk. “Hedging” is when you are making a transaction that counteracts a market move that can cause you a financial loss. In this case, you are trying to hedge against currency or foreign exchange risk.

  1. Exchange the money upfront
  2. Purchase a forward contract
  3. Use a process called Net-Netting (advanced users only)
  4. Purchase a future contract (advanced users only)
  5. Purchase an option or swap (advanced users only)

Exchanging Your Money Upfront

Let us say you are buying an antique from Canada. The seller will only accept Canadian dollars (CAD). If the purchase is today and you receive the goods today, you are doing what is called a “spot” transaction. You can go to the bank or a currency exchanger and ask for today’s spot price, and that is the rate at which you will exchange. You hand over the Canadian dollars, and the seller hands you the antique, case closed.

What if you agree to the price now, but have to pay in the future? This happens a lot with a business that is buying parts from a Canadian supplier for their product that is assembled in the United States, such as your new shark mounted laser beams. Now your laser beam business is exposed to “currency risk.” This means that between now and the time you pay, the exchange rate can change, either in your favor or against you. Let us look at the potential outcomes, assuming that today’s exchange rate is $1 to 1 CAD:

Currency Exchange Scenarios

We have determined that exchange rates can randomly determine bonus time vs angry time, depending on how they move. One method used to protect against angry time is to exchange your money upfront. Going back to our shark laser example, you can exchange the money upfront, when the contract is signed, and wait with your Canadian dollars until it is time to pay. The upside is that you have effectively eliminated any risk that the exchange rate can move against you. However, you have given up any chance that the exchange rate moves in your favor. You give up bonus time to prevent angry time.

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Using a Forward Contract

What if you want to keep today's exchange rate, but not actually exchange your money until the date you have to? Maybe you are saving up for a big vacation or other big purchase, or perhaps you are a company that is buying raw materials for products you are making three months from now. Using a 'Forward Contract' means that you commit to exchanging your money later, on a specific agreed-upon date, rather than 'up front' like in the previous section. Remember, time is money! You might not have all the cash in your possession for the future purchase, but today's rate might be good enough that you want to make sure you keep it for when you DO make the exchange.

Going back to our example, if you know that you have to pay your Canadian supplier in 30 days, you can buy a forward contract that locks in the 1:1 USD to CAD exchange rate for that time period. There are advantages and disadvantages:

  1. You are still making the same trade off as with exchanging your money upfront: giving up bonus time to prevent angry time. However, you do not have to lock up the currency when you buy the forward contract. You are obliged to do the exchange at the end date of the contract. This is useful if you do not have the cash upfront or if the end date is a long time into the future.
  2. You have to pay for this service, and that charge varies, but between 5 and 10% of the total amount you are trying to protect is common.
  3. If you have to get out of the contract, you will have to pay fees. Think of this like in a certificate of deposit (CD), the early withdrawal fee.
  4. If the exchange rate moves a lot, some banks require a margin (a minimum amount in your account) or “top up” to make sure you will honor your side of the bargain.

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Using Net-Netting, Options, Futures, and Swaps

For those that are confident in their math skills and interested in learning esoteric theories, net-netting, options, futures, and swaps are for you. We will be covering these products in the “Advanced Protection Methods” section (coming soon to an internet near you!)

Now what to do? Try out our calculator to see if our product can help you with your currency risk. Contact us with any comments or questions. Useful lingo and currency symbols are below.

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Industry Lingo

  • Ask Price: The exchange rate a trader or bank is willing to use to transfer funds by selling you a particular currency. This is often half of a “bid/ask spread,” see that definition for an example.
  • Bid Price: The exchange rate a trader or bank is willing to use to transfer funds by buying from you a particular currency. This is often the other half of a “bid/ask spread,” see that definition for an example.
  • Bid/Ask Spread: When you ask a bank or trader for a price to exchange your currency, they will often quote you the bid/ask spread. An example:

Today’s exchange rate between dollars (USD) and Euros (EUR) is 1.2 USD per EUR. This means you will receive 1.2 USD for every EUR you exchange. You can typically find this rate by using a search engine. When you enter the bank or airport, the person at the exchange desk will say “The bid/ask spread is .01 ticks, so we will sell USD at the bid price of 1.21 and buy at the ask price EUR for 1.19.” Sound confusing? Well it is. The rule of thumb is to look at your transaction and see which rate is worse for you. That is the rate you will receive. So in our case, if you are changing dollars for Euros, a rate of 1.19 USD/EUR is better than 1.21 USD / EUR. Therefore, the rate you get from the bank is the 1.21 USD / EUR.

  • Currency Risk: The amount of money you can gain or lose if the exchange rate moves. Used in a sentence: “I have currency risk if I agree to a price in another currency today and have to pay at some point in the future, since the rate could change between now and then.”
  • Exchange Rate: The rate used to determine how much of the other currency you will receive. If the USD / EUR rate is 1.2, that means you will receive $1.2 for every Euro you exchange. If you take the reciprocal (1/1.2 = .83) you will receive .83 Euros for every dollar you exchange. Typically, exchange rates for a currency pair are only quoted using one method, so it is up to you to do the division if that makes it easier for you to think about. For USD / EUR it is typically quoted to four decimal places such as “1.2222 USD per EUR.”
  • Foreign Exchange Rate/FOREX/FX: These terms are used interchangeably to mean an exchange rate between two currencies.
  • Gross Domestic Product/GDP: The total output of an economy, measured in a specific currency.
  • Spot Rate: This is the exchange rate you can get right now. It has changed from when you started reading this definition.

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Commonly Traded Currencies: Countries, Names, and Symbols

  1. Australia - Australian Dollar (AUD)
  2. Brazil - Brazilian Real (BRL)
  3. Canada - Canadian Dollar (CAD)
  4. China - Renminbi (RMB) also called the Yuan
  5. Czech Republic - Czech Koruna (CZK)
  6. European Union - Euro (EUR)
  7. Great Britain (England) - English Pound Sterling (GBP)
  8. Hungary - Hungarian Forint (HUF)
  9. India - Indian Rupee (INR)
  10. Israel - Israeli Shekel (ILS)
  11. Japan - Japanese Yen (JPY)
  12. Mexico - Mexican Peso (MXN)
  13. Norway - Norwegian Krone (NOK)
  14. Poland - Polish Zloty (PLN)
  15. Russia - Russian Ruble (RUB)
  16. South Africa - South African Rand (ZAR)
  17. Sweden - Swedish Krona (SEK)
  18. Switzerland - Swiss Franc (CHF)
  19. Turkey - Turkish Lira (TRY)
  20. United States - United States Dollar (USD)

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References

  1. World Bank. 2012. Exports of goods and services (% of GDP). © World Bank. http://data.worldbank.org/indicator/NE.EXP.GNFS.ZS/countries/US?display=graph License: Creative Commons Attribution CC BY 3.0.

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