What it means
If you want to pay a supplier in euros but your bank account is in US dollars, you must convert the money at an exchange rate. A quoted rate of 1.10 for the euro against the dollar means that one euro costs $1.10.
Rates are quoted in pairs, and the first currency is the base, the one being priced. Rates move constantly because of supply and demand in the foreign exchange market.
Interest rate differences, inflation, economic growth, trade balances and political events all influence how much a currency is worth. A country's central bank may also intervene, or may fix the rate in some systems, though many major currencies float freely.
Dealers quote two prices: a bid, at which they will buy the base currency, and an ask, at which they will sell it. The gap between them, called the spread, is the dealer's margin and a real cost for the customer.
Banks and card providers may add further fees on top of the market rate. For businesses, exchange rates create several kinds of exposure.
Transaction exposure arises when a sale or purchase is priced in a foreign currency and the rate changes before payment. Translation exposure appears when overseas results are converted into the reporting currency, and economic exposure reflects the longer-term effect of currency swings on competitiveness.
Companies manage this risk through natural hedging, such as matching foreign currency income with costs, or through forward contracts, options and swaps. Finance teams should also record which rate is used in the accounts, typically the spot rate on the transaction date for individual deals and an average or closing rate for period reporting.
Accounting rules require foreign currency transactions to be recorded at the spot rate on the transaction date. If the rate has changed by the time the invoice is paid or the balance is reported, the difference is recorded as a foreign exchange gain or loss in profit.
This is why a business with no change in its operations can still report different profits when currencies move.
In practice
Real-world examples
Example 1
An online retailer sells to customers in several countries. Each sale is converted at the rate on the day of payment, and the resulting small gains and losses are recorded as foreign exchange differences. At the end of the month, unpaid foreign currency invoices are revalued at the closing rate.
Example 2
A manufacturer imports components priced in another currency. When that currency strengthens by 6%, the cost of the components rises by about the same amount, so the manufacturer renegotiates its selling prices. The company also checks whether a supplier in its own country could provide the same parts.
Example 3
A multinational group translates the results of its overseas subsidiary into dollars for its consolidated accounts. A weaker local currency reduces the reported dollar profit even though the subsidiary performed well in its own market. Management reports the result in local currency as well, so that the subsidiary's real performance can be judged.
Think of it
Think of an exchange rate like the conversion rate at a theme park ticket booth where you swap your local cash for tokens to ride the rollercoasters. The price of tokens changes daily depending on how many people want to ride.
Formula
Calculation
Amount in quote currency = Amount in base currency x Exchange rate
A US company, Summit Tools, a fictional business, invoices a European customer for 200,000 euros when the rate is 1.10 dollars per euro. The expected receipt is 200,000 x 1.10 = $220,000. If the euro weakens to 1.05 before payment, the receipt is 200,000 x 1.05 = $210,000. The company loses $220,000 - $210,000 = $10,000 purely because of the rate movement. A forward contract fixing the rate at 1.10 would have protected the full $220,000.Case study
Seen in the real world
Alpine Gear is an illustrative, fictional exporter that sold climbing equipment to European retailers, invoicing in euros. Its margin on each sale was 12%, and orders were paid 90 days after shipment.
During one quarter the euro weakened by 7% against the dollar. Because the cost base was in dollars and revenue in euros, the weaker euro wiped out most of the 12% margin on the orders in transit.
In the illustrative response, the CFO began using forward contracts to lock the rate for confirmed orders and added a currency adjustment clause to price lists. The following year, margins held steady even when the currency moved, and the board added foreign exchange exposure to the regular risk report. Alpine's sales team now quotes prices in dollars to large customers, shifting some currency risk to the buyer.
Watch out
Common mistakes
- Reading the quote the wrong way round, so that the base and quote currencies are confused.
- Using today's rate to value a future payment without allowing for movement before settlement.
- Ignoring the spread and fees, which can make the real cost higher than the headline rate.
Questions
People also ask
What moves exchange rates?
Interest rates, inflation, economic data, trade flows and political events all influence supply and demand for a currency.
What is the difference between spot and forward rates?
The spot rate applies to immediate settlement, while a forward rate is agreed now for exchange on a future date.
How can a business reduce its exchange rate risk?
It can invoice in its own currency, match income and costs in the same currency, or use forward contracts and options.