Does your business:

• Make income from overseas operations?
• Import or export goods and services from abroad?
• Pay overseas invoices?
• Or interact with foreign currencies in any way?

If so, your business can be impacted by exchange rate movements. Whether you’re a sole proprietor or a large corporation, in manufacturing or healthcare, you will face some level of foreign exchange risk when making international payments.

What is foreign exchange risk?

It’s exactly what it sounds like: it’s the possibility that a business’s financial position or performance could be negatively impacted by fluctuations in exchange rates in the foreign currency markets. As the saying goes, the markets never sleep. Exchange rates are prone to fluctuations at any given moment, and while experts can forecast where they think currency values might go, you can’t predict where the rates could go—or what it could mean for your business. Let’s take a look at a few examples.

How does a falling domestic exchange rate affect your business?

A falling domestic exchange rate can:

• Increase costs for importers and potentially reduce their profitability.
• Make domestically produced products more competitive against imported products.
• Increase the cost of capital expenditure (for example, if it includes the importation of capital equipment).
• Increase the cost of servicing foreign currency debt.
• Improve exporter competitiveness.
• Make a business a more attractive investment proposition for foreign investors.
• Increase the costs of investing in overseas operations.

How does a rising domestic exchange rate impact your business?

On the other hand, a rising domestic exchange rate can:

• Make exports less competitive, reducing exporter profitability.
• Decrease the value of investment in foreign subsidiaries and monetary assets (when translating the value of such assets into the domestic currency).
• Reduce foreign currency income from investments.
• Reduce the cost of foreign raw materials, giving importers a competitive advantage.
• Reduce the value of foreign currency liabilities and hence the cost of servicing these liabilities.
• Reduce the cost of capital expenditure (for example if it includes the importation of capital equipment).
• Make a business less attractive to foreign investors.

Did you notice anything? No matter which direction the exchange rate is moving, it could have the potential to impact your business—and your bottom line.

How can you protect your business from market volatility?

No one can predict how the markets will move, but a knowledgeable FX provider can give your business the guidance and solutions to help you to make informed decisions to minimize the impact of market motion.

Are you curious to know more about XE?

At this time, the onset of 2021 has brought a bout of US dollar (USD) strength. The USD Index has risen 2.2% from its 34-month low set on January 6th. This recent strength is a major contrast with the -15% performance the USD experienced over the prior nine months.

USD at a glance

What’s impacting the dollar right now?

• Unemployment fell to 6.3% today from 6.7% last month.

• The US Treasury bond yield curve is upward sloping and at higher interest rate levels, pointing toward a continued recovery.

• The IMF, Goldman Sachs and other large investment firms are calling for a boom 2nd half to 2021.

• COVID-19 cases have fallen dramatically in the US this week, and Johnson & Johnson is about to announce their vaccine.

These data points all hint towards positive US economic growth as 2021 continues.

Given the new U.S. presidential administration and the development of COVID-19 vaccinations, market participants are wondering what’s in store for the USD in 2021. To answer this question, it’s important to first review the dollar’s recent history.

The US dollar in review

From 2011 to early 2020, the dollar appreciated nearly +28% as global investors flocked to the US markets to buy US assets and participate in the booming US economy. This dollar uptrend held despite then-President Trump’s efforts to talk down the dollar, as higher US treasury yields and continued equity market returns kept the dollar firm.

Then COVID-19 struck in March 2020, changing everything.

The dollar initially sank in sympathy as global equity markets began to unravel. However, once the magnitude of COVID-19’s economic impact became more apparent, a new market “risk aversion” theme took hold. Investors quickly bailed on risky assets and flocked to USD-denominated “safe-haven” assets en masse, believing they would be more likely to maintain their value and hold steady even as financial markets crumbled.

In just two weeks, this mad dash into safe-haven USD assets spiked the USD Index +7.5% and left the USD with an artificial “risk aversion” premium built into its value from its perceived low uncertainty.

It has been this risk-aversion premium that then most influenced the USD’s 2020 USD trading.  For the prior nine years, traders had bought USD on good investor news to invest in US assets In the new COVID-19 world, traders did the opposite, selling USD on good market news.

Why?

Because traders were already overweight US assets and even more so with the newly purchased safe haven assets. So, as 2020 unfolded and the investment climate improved due to central bank and government actions, the need for safe-haven assets diminished and traders began unwinding these positions.

And, with this, the negative equity market correlation was born, and flipped risk-on and risk-off its head.

Ordinarily, the value of USD assets would rise in conjunction with increased market optimism (risk-on), and uncertainty or negativity would drive investors to sell their riskier assets in favor of safer ones (risk-off). Good news for investors would mean good news for the dollar, and the same with bad news.

Now, good news for investors was bad news for the dollar, and bad news for investors was good news for the dollar.  Economic fundamentals didn’t matter.

This theme held strong for the remainder of 2020. If US stocks went up (and they did!), then the USD would fall (and it did!). It was virtually guaranteed.

What’s going to happen in 2021?

To answer that question, we’ll need to consider two key questions.

1. Will 2021 be a continuation of 2020’s risk-aversion trading theme?

2. Will traders conclude that the USD risk-aversion premium has been wiped out and it is time to start trading off market fundamentals?

Up until this week, 2021 FX trading was looking just like 2020. Post-US election equity markets surged on the elimination of election risk, positive vaccine news and the idea of a large US fiscal stimulus package. Unsurprisingly, the USD fell -6%. And on January 6th, after the storming of the US Capitol, when uncertainty was reintroduced to the markets, the USD rose 2%.

So, what will it be for the dollar going forward? It depends on whether or not you believe the risk-aversion trading scenario will continue.

• If you do believe this, then you likely believe the US dollar will continue to depreciate as global equity markets continue to move higher.

• If you don’t believe this, then you believe the worst of the pandemic is over, traders have priced out the “risk-aversion premium” to the dollar, and that the USD will trade on fundamentals again—meaning good economic data and continued equity market returns will strengthen the USD.

In conclusion?

Should 2020’s risk-on and risk-off trend reverse, we will see a strong US dollar. The IMF recently raised the US’s 2021 GDP forecast to 5.1% from 3.1%, which was an outlier to the EU.

Additional vaccines coming onto the market could boost confidence, as would an additional fiscal stimulus package. The US could see unleashed economic growth in the second half of 2020, continuing to draw global capital.  Additionally, some currency moves may have gone too far, and natural flows will come back to the USD and US markets.

If February’s first week of trading is any indication, it looks like 2020’s negative correlation has broken as both the dollar and equity markets rallied in sync.

If you’re traveling abroad for a holiday, need to pay for a school fee in another country or you want to buy an item from a foreign country,  you will need a currency exchange to carry out your transaction. But how can you tell the exact amount your currency is worth when it is exchanged into a foreign currency? And who’s setting them?

For the first question, you can easily do that on Xe’s Currency Converter. The second question? That’ll take a little more time to understand. We’ll try to make it as quick (and painless) as possible for you!

Currency exchange rates: what they are, and how they work

Exchange rates indicate how much your currency is worth if exchanged into a foreign currency. For example, on December 30, 2020, 1 U.S. dollar was equal to 0.748067 British pounds.

Currency exchange transactions happen 24 hours a day, seven days a week in a market that transact over $6 trillion a day. Exchange rates are constantly fluctuating as foreign currencies are actively traded. Various trading activities boost or lower the values of different currencies.

Institutions and traders buy and sell foreign currencies in the global market 24 hours a day. For a trade to be completed, at least one currency must be exchanged for another. For example, in order to buy the U.S. dollar another currency is required for payment. Whatever currency is used, either the euros, yen, or Canadian dollar, etc. will create a currency pair. For example, if you use U.S. dollars (USD) to buy the Japanese yen, the exchange rate will be for the JPY/USD pair.

How are international exchange rates determined?

Foreign exchange rates are determined in various countries using two key methods: flexible and fixed rate. While flexible exchange rates are constantly changing, fixed rates hardly ever change. (Though you probably figured that out from their names.)

Flexible exchange rates

The foreign exchange market or forex determines most currency exchange rates. These rates are known as flexible exchange rates. These rates are constantly changing from one moment to the next. Flexible exchange rates are influenced by the open market through demand and supply on world currency markets. As such, if the demand for a specific currency is high, the value of such currency will most likely increase. But if the demand of a particular currency falls, its value in the foreign exchange market falls too.

Most major global currencies often have flexible exchange rates. These include the British pounds, Mexican pesos, European euros, Japanese yen, Canadian dollars, and others.

The government of these countries and their central banks do not interfere to keep their exchange rates fixed. Though their policies can affect rates in the long run, for most of these nations their governments can only impact and not regulate exchange rates.

Fixed exchange rates

Countries that use fixed or pegged foreign exchange rates do so via their central bank. These countries set their rate against another major world currency like the United States dollar, euro or yen.

To regulate and maintain the fixed exchange rate, the government of these countries buy and sell their own currency against the foreign currency to which it is pegged. Only the governments of these countries can determine when their foreign exchange rates should change.

Countries that use the fixed exchange rate method include Saudi Arabia and China. These countries ensure that their central banks have sufficient amounts of money in their foreign currency reserves to determine the amount their currency is worth in the foreign exchange market.

Okay, but what causes the rates to change?

Rates change when currency values change. There are several key factors that affect the movement and values of local and foreign currencies. These include three key factors known as:

1. Interest rates

2. Money supply

3. Financial stability

Due to these factors, the demand for a particular country’s currency, depends on what is happening in that country.

Interest rates

The interest rates a country’s central bank is setting is a key factor that will influence the country’s exchange rate. Higher interest rates have positive impacts on the value of the country’s currency. Investors are more likely to exchange their currency for one with higher interest rates, and then save it in that country’s bank to benefit from the higher interest rate.

Money supply

The money supply made available by a country’s central bank can influence the value of the currency in the foreign exchange market. For example, if there is too much money in circulation, there will be too much of it in exchange for very few goods.

Currency holders will most likely bid up the costs of goods and services which will trigger inflation. In the event that too much money is printed and in circulation in a particular country, it triggers hyperinflation and drives down their currency value in the foreign exchange market. Cash holders prefer to invest in countries with little or no inflation.

Financial stability

The financial stability and economic growth of a country can affect its foreign exchange rates. Investors are more likely to buy goods and services from countries with a strong and growing economy. This means they will need more of such a country’s currency to buy from them. this will increase the demand for such currency and ultimately boosts its value in the foreign exchange market.

If the economy of the country is in a bad shape, investors are less likely to trade with them. Investors are only interested in trading with countries that can provide gains from holding government bonds in that currency.