What it means
Currencies always trade in pairs, because a price only means something in relation to another currency. A quote of 1.0800 for the euro against the US dollar means one euro costs 1.0800 dollars, so the first currency named is what you are buying and the second is what you are paying with.
The market operates continuously from Monday morning in Asia to Friday evening in North America, and daily volumes run into trillions of dollars. That depth means the major pairs are extremely liquid, so a corporate treasurer can move large sums without noticeably shifting the price.
Prices move on interest rate expectations, inflation data, trade balances, political events and simple flow, but the practical point for a business is that they move at all. A 5% shift in a currency over a quarter is unremarkable, and it can erase the entire margin on an import contract priced months earlier.
Every quote has two sides: a bid at which the dealer will buy and an ask at which the dealer will sell, and the gap between them is the spread. The spread is the real cost of transacting, and it widens for smaller amounts, exotic currencies and volatile moments.
Businesses use the market in two very different ways. Hedging locks in a known rate so that a future cost or receipt becomes certain, while speculation takes a position hoping the rate moves in your favour, and confusing the two is how treasury departments get into trouble.
In practice
Real-world examples.
Example
An electronics importer agrees a $2,000,000 order priced in a foreign currency with payment due in 90 days. Between order and payment the currency strengthens by 4%, adding $80,000 to the cost and turning a planned 6% margin into a 2% one. The buyer starts quoting prices with a currency clause after that experience.
Example
An exporter of industrial parts earns 60% of revenue abroad and watches its home currency strengthen through the year. Reported revenue falls in home currency terms even though unit volumes rose, so management reports growth at constant currency alongside the statutory figures.
Example
A private investor with a foreign share portfolio worth $250,000 sees the shares rise 8% while the currency falls 6%. The combined return is far weaker than the share performance alone, which is the point at which the investor learns that currency exposure is part of the portfolio whether it was chosen or not.
Formula
Calculation
Profit or loss on a currency position = notional amount x (closing rate - opening rate). Return in percentage terms = profit / (notional amount x opening rate).
A treasury desk buys 500,000 euros against the US dollar at a rate of 1.0800. The dollar cost is 500,000 x 1.0800 = $540,000. Three weeks later the pair trades at 1.0950 and the desk sells the position, receiving 500,000 x 1.0950 = $547,500. The gain is $547,500 - $540,000 = $7,500. As a percentage of the amount committed that is $7,500 / $540,000 = 1.39%, which shows how a small-looking move of 150 points in the rate translates into a meaningful sum on a large notional.Case study
Seen in the real world.
This is a fictional, illustrative example. Calderwood Textiles, an invented clothing wholesaler, bought most of its stock from overseas mills and priced its own catalogue once a year, in advance, for the whole season. Purchasing was done at whatever the spot rate happened to be on the day each order was placed.
Over one season the currency in which it bought moved roughly 7% against it. Because selling prices were already printed and committed, the entire movement landed on gross margin, cutting it from 34% to 28% and wiping out most of the year's profit growth.
The fictional company's response was not to trade currencies but to stop being accidentally exposed to them. It began buying forward cover for around 70% of expected purchases as soon as the catalogue was priced, accepting a known rate in exchange for giving up any windfall if the market moved the other way.
Watch out
Common mistakes.
- Treating currency exposure as something only exporters have, when importers, foreign subscription buyers and overseas investors all carry it.
- Reading the quoted rate as the rate you will get, ignoring the bid-ask spread and any margin the bank adds on top.
- Letting a hedging programme drift into speculation by leaving positions open after the underlying commercial exposure has been settled.
Questions
People also ask.
Is the forex market open at weekends?
No, mainstream trading closes late on Friday and reopens on Sunday evening or Monday morning depending on the time zone, so weekend news can produce a gap at the open.
Should a small business hedge its currency exposure?
If a single currency movement of 5% would materially damage the year's profit, then yes, and a simple forward contract is usually enough without any complex instruments.
What causes exchange rates to move?
Interest rate expectations, inflation, trade flows and political events all matter, though short-term moves are frequently driven by positioning rather than any identifiable news.
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