What it means
Every rate is a pair, and reading the pair correctly is where most confusion starts. EUR/USD at 1.10 means one euro buys 1.10 US dollars, so if the number rises the euro has strengthened, and a business quoting the same figure the other way round will get the opposite impression.
Rates matter to any company that buys, sells, borrows or holds cash in a foreign currency. An exporter invoicing in a customer's currency carries the risk that the currency weakens before payment arrives, which turns a healthy quoted margin into a thin realised one.
There are several rates in daily use, and mixing them up is expensive. The spot rate is for near-immediate settlement, the forward rate fixes a price for a future date, and the rate a bank actually offers a customer includes a spread that can be one or two per cent away from the mid-market rate quoted in the news.
Cross rates are derived rather than quoted directly. If EUR/USD is 1.10 and USD/JPY is 150, then one euro buys 1.10 x 150 = 165 yen, and this arithmetic is how banks price pairs that have no deep direct market.
Accounting adds a second layer. Transactions are usually recorded at the rate on the transaction date, then any balance still outstanding is restated at the closing rate on the reporting date, and the difference is reported as a foreign exchange gain or loss.
In practice
Real-world examples.
Example
A UK furniture importer buys containers from Vietnam priced in US dollars and finds its landed cost rises 7% in a quarter without any supplier price increase, purely because sterling weakened. It starts quoting customers with a three-month price validity instead of six.
Example
A Canadian software firm bills 40% of revenue in US dollars but pays almost all its costs in Canadian dollars. A strengthening Canadian dollar squeezes margins even though sales volumes grow, and the board asks for a hedging policy.
Example
A travel operator holds euro cash to pay hotels and restates that balance at the closing rate each month end. The revaluation creates gains and losses in the accounts that have nothing to do with how many holidays were sold.
Formula
Calculation
Home currency amount = Foreign currency amount x Exchange rate (home currency per unit of foreign currency)
A US components maker invoices a European customer EUR 250,000 when EUR/USD is 1.10, so the sale is recorded at EUR 250,000 x 1.10 = $275,000. The customer pays 90 days later when the rate has fallen to 1.06, so the cash actually received is EUR 250,000 x 1.06 = $265,000. The foreign exchange loss is $275,000 - $265,000 = $10,000, and the rate move itself is (1.06 - 1.10) / 1.10 = -3.6%.Case study
Seen in the real world.
Torrance Optics is a fictional lens manufacturer created for this illustrative case. Based in the United States, it won a two-year contract to supply a European distributor at a fixed price of EUR 400,000 a quarter, and the sales director celebrated a contract worth $1,760,000 a year at the prevailing rate of 1.10.
Nobody had asked what would happen if the euro weakened. Over the following year the rate drifted to 1.02, so quarterly receipts fell from EUR 400,000 x 1.10 = $440,000 to EUR 400,000 x 1.02 = $408,000, a shortfall of $32,000 a quarter and $128,000 a year. The gross margin on the contract had been budgeted at $150,000 a year, so most of it had evaporated.
For the second year the finance director sold euros forward for each expected receipt, fixing the rate and removing the uncertainty. The illustrative point is not that hedging makes money, because it usually does not, but that it lets a business keep the margin it thought it had won.
Watch out
Common mistakes.
- Reading a currency pair backwards, so a rate rise is interpreted as the wrong currency strengthening.
- Budgeting overseas sales at the mid-market rate seen in the news, ignoring the spread the bank will actually charge.
- Assuming that invoicing in your own currency removes the risk, when it simply moves the risk to the customer, who may ask for a discount or walk away.
Questions
People also ask.
What makes exchange rates move?
Mainly interest rate differences, inflation expectations, trade flows and investor sentiment, with politics adding short-term volatility.
Should a small business hedge?
It depends on exposure, but a simple forward contract on known future receipts is often enough, and hedging is about certainty rather than profit.
What is the difference between spot and forward rates?
Spot is for near-immediate settlement, while a forward fixes today the rate for an agreed future date.
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