What it means
Currencies are always quoted in pairs, because a price only means something relative to another currency. A quote of EUR/USD 1.2500 says that one euro costs 1.25 US dollars, with the euro as the base currency and the dollar as the quote currency.
Trading happens in three main forms: spot deals that settle within a couple of days, forwards that fix a rate for a future date, and swaps that combine the two. Banks, corporate treasuries, asset managers and central banks all take part, which is why the market is deep enough to absorb very large orders without moving much.
For a business, the FX market matters because it silently changes the value of foreign revenue and foreign costs between the day you agree a price and the day you get paid. A 5% currency move on an export contract can wipe out the entire profit margin on that contract without a single thing changing in the underlying business.
In practice, most companies use the market in two ways: converting cash they already have or owe, and hedging cash they expect. A finance team might buy a forward contract covering 80% of next quarter's expected euro receipts, leaving a slice unhedged in case forecast volumes fall short.
The nuance that catches people out is the difference between the mid-market rate they see quoted online and the rate they are actually given. Banks and payment providers earn a spread between their buying and selling prices, and on smaller transfers that spread can cost far more than any explicit fee.
In practice
Real-world examples.
Example
A furniture importer pays Vietnamese suppliers in dollars but sells in Canadian dollars, so a weakening loonie quietly raises its landed cost per container. The buying team starts hedging six months of purchase orders forward so that price lists can hold for a full season.
Example
A London-based consultancy wins a two-year contract billed in dollars. Its treasurer sets up a rolling series of forward sales so the sterling value of each monthly invoice is known in advance and can be built into the salary budget.
Example
A travel operator collects deposits in euros in winter for trips it will pay for in Turkish lira in summer. Because the gap between collecting and paying is several months, the operator buys the lira forward rather than gambling on the spot rate at the time of travel.
Think of it
“FX market is the foreign exchange marketplace-where currencies trade globally.
Formula
Calculation
Home currency amount = foreign currency amount x exchange rate expressed as home currency per unit of foreign currency.
A US software company invoices a German customer for EUR 1,600,000, payable in 90 days. On the day it raises the invoice the spot rate is 1.2500 dollars per euro, so it books expected proceeds of 1,600,000 x 1.2500 = $2,000,000.
Ninety days later the euro has weakened to 1.1500. The company receives 1,600,000 x 1.1500 = $1,840,000, which is $160,000 less than expected, an 8% shortfall on the invoice value. Had the treasurer instead sold the euros forward at the 90-day forward rate of 1.2450, the company would have locked in 1,600,000 x 1.2450 = $1,992,000, giving up $8,000 against the original spot expectation in exchange for complete certainty.Case study
Seen in the real world.
Harbourline Instruments is a fictional, illustrative maker of laboratory equipment based in the United States, with roughly 40% of sales invoiced in euros and sterling. For years the company converted foreign receipts to dollars whenever they arrived, which meant its reported margin moved with the currency market rather than with its own performance.
After a quarter in which a 6% currency swing turned a small operating profit into a loss, the illustrative board asked for a policy rather than a habit. The treasurer introduced a rule of hedging 75% of forecast foreign receipts out to six months using forward contracts, reviewed monthly, with the unhedged quarter left open to absorb forecast error.
The currency market kept moving, but reported margins stopped jumping around, and the sales team could finally quote foreign prices for a full quarter without the finance team objecting. Nothing about the underlying business changed; what changed was that FX volatility was no longer being mistaken for trading performance.
Watch out
Common mistakes.
- Believing that only exporters and importers have currency exposure. A company buying cloud services priced in dollars, or competing against a foreign rival, is exposed too, even if every invoice it issues is in its home currency.
- Comparing providers on headline fees alone. The spread built into the exchange rate is usually the larger cost, so the rate itself must be compared against the mid-market rate on the same day.
- Hedging 100% of a forecast. If actual volumes come in below plan, the company is left holding currency contracts it does not need and must close them at whatever the market offers.
Questions
People also ask.
Is the FX market open 24 hours a day?
Effectively yes on weekdays, because trading passes from Asia to Europe to North America, but it closes over the weekend and liquidity thins in the gaps.
What actually moves exchange rates?
Interest rate differences, inflation, trade and investment flows and expectations about central bank policy do most of the work, though short-term moves often defy any tidy explanation.
Should a small business hedge at all?
If foreign currency amounts are small relative to profit, natural matching of income and costs may be enough, but once a single contract's currency swing could change the annual result, a simple forward policy is worth having.
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