Each country has a currency in which the prices of goods and services are quoted. In the United States, it is the dollar ($); in Great Britain, the pound (£); in France, Germany, and the other 15 members of the euro zone it is the euro (€); in Japan, the yen (¥); and so on. In general, within the borders of a particular country, one must use the national currency. A U.S. tourist cannot walk into a store in Edinburgh, Scotland, and use U.S. dollars to buy a bottle of Scotch whisky. Dollars are not recognized as legal tender in Scotland; the tourist must use British pounds. Fortunately, the tourist can go to a bank and exchange her dollars for pounds. Then she can buy the whisky.
When a tourist changes one currency into another, she is participating in the foreign exchange market. The exchange rate is the rate at which the market converts one currency into another. For example, an exchange rate of €1 = $1.30 specifies that 1 euro buys 1.30 U.S. dollars. The exchange rate allows us to compare the relative prices of goods and services in different countries. Our U.S. tourist wishing to buy a bottle of Scotch whisky in Edinburgh may find that she must pay £30 for the bottle, knowing that the same bottle costs $45 in the United States. Is this a good deal? Imagine the current pound/dollar exchange rate is £1.00 = $2.00 (i.e., one British pound buys $2.00). Our intrepid tourist takes out her calculator and converts £30 into dollars. (The calculation is 30 × 2.) She finds that the bottle of Scotch costs the equivalent of $60. She is surprised that a bottle of Scotch whisky could cost less in the United States than in Scotland (alcohol is taxed heavily in Great Britain).
Tourists are minor participants in the foreign exchange market; companies engaged in international trade and investment are major ones. International businesses have four main uses of foreign exchange markets. First, the payments a company receives for its exports, the income it receives from foreign investments, or the income it receives from licensing agreements with foreign firms may be in foreign currencies. To use those funds in its home country, the company must convert them to its home country’s currency. Consider the Scotch distillery that exports its whisky to the United States. The distillery is paid in dollars, but because those dollars cannot be spent in Great Britain, they must be converted into British pounds. Similarly, Toyota sells its cars in the United States for dollars; it must convert the U.S. dollars it receives into Japanese yen to use them in Japan.
ANOTHER PERSPECTIVE How Foreign Exchange Challenges Business Travel Ethics
In preparation for a trip to Japan, you exchange U.S. dollars for yen in late May, just before you leave. For $1,000, your bank gives you ¥104,000. During your time in Osaka, the dollar weakens against the yen, to ¥99.5 to the dollar. Meanwhile, you enjoyed Japanese hospitality and spent only ¥10,000. Back home, you take your remaining ¥94,000 to the bank to convert back to dollars. How much have you spent on your trip?
The foreign exchange market enables companies based in countries that use different currencies to trade with each other.
Second, international businesses use foreign exchange markets when they must pay a foreign company for its products or services in its country’s currency. For example, Dell buys many of the components for its computers from Malaysian firms. The Malaysian companies must be paid in Malaysia’s currency, the ringgit, so Dell must convert money from dollars into ringgit to pay them.
Third, international businesses also use foreign exchange markets when they have spare cash that they wish to invest for short terms in money markets. For example, consider a U.S. company that has $10 million it wants to invest for three months. The best interest rate it can earn on these funds in the United States may be 2 percent. Investing in a South Korean money market account, however, may earn 6 percent. Thus, the company may change its $10 million into Korean won and invest it in South Korea. Note, however, that the rate of return it earns on this investment depends not only on the Korean interest rate, but also on the changes in the value of the Korean won against the dollar in the intervening period.
Involves short-term movement of funds from one currency to another in hopes of profiting from shifts in exchange rates.
Currency speculation is another use of foreign exchange markets. Currency speculation typically involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates. Consider again a U.S. company with $10 million to invest for three months. Suppose the company suspects that the U.S. dollar is overvalued against the Japanese yen. That is, the company expects the value of the dollar to depreciate (fall) against that of the yen. Imagine the current dollar/yen exchange rate is $1 = ¥120. The company exchanges its $10 million into yen, receiving ¥1.2 billion ($10 million × 120 = ¥1.2 billion). Over the next three months, the value of the dollar depreciates against the yen until $1 = ¥100. Now the company exchanges its ¥1.2 billion back into dollars and finds that it has $12 million. The company has made a $2 million profit on currency speculation in three months on an initial investment of $10 million! In general, however, companies should beware, for speculation by definition is a very risky business. The company cannot know for sure what will happen to exchange rates. While a speculator may profit handsomely if his speculation about future currency movements turns out to be correct, he can also lose vast amounts of money if it turns out to be wrong.