FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-

FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-

rencies of other countries. Financial managers must be aware of the issues relating to dealing with multiple currencies. In particular, the financial man- ager must be aware of exchange rate and the related currency risk.

Exchange Rates The exchange rate is the number of units of a given currency that can be

purchased for one unit of another country’s currency; the exchange rate

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tells us about the relative value of any two currencies. The exchange rate can be quoted in term of the number of units of the domestic currency rel- ative to a unit of the foreign currency (referred to as a direct quotation), or in terms of the number of units of the foreign currency relative to a unit of the domestic currency (referred to as an indirect quotation).

Consider the exchange rate of U.S. dollars and Swiss francs. From the perspective of the U.S. firm, the exchange rate would be the number of U.S. dollars needed to buy a Swiss franc. If the rate is 0.70, this means that it takes $0.70 to buy one Swiss franc, 1CHF. From the per- spective of the Swiss firm, the rate is US$0.70/1CHF = 1.4286; that is, it takes 1.4286 Swiss francs to buy one U.S. dollar.

Countries have different policies concerning their currency exchange rate. In the floating exchange rate system, the currency’s foreign exchange rate is allowed to fluctuate freely by supply and demand for the currency. Another type of policy is the fixed exchange rate system, where the gov- ernment intervenes to offset changes in exchange rates caused by changes in the currency’s supply and demand. The third type of policy is a man- aged floating exchange rate system, which falls somewhere between the fixed and floating systems. In the managed floating rate system, the cur- rency’s exchange rates are allowed to fluctuate in response to changes in supply and demand, but the government may intervene to stabilize the exchange rate in the short-run, avoiding short-term wild fluctuations in the exchange rate.

The international foreign currency market has undergone vast changes since the gold standard was abolished in 1971. Prior to August 1971, the value of the U.S. dollar was tied to the value of gold (fixed at $35 per ounce) and the value of other countries’ currency was tied to the value of the U.S. dollar. In other words, the world’s currencies were on a type of fixed exchange rate system. Since August 1971, the values of the U.S. dollar and other currencies have been allowed to change according to supply and demand. However, the United States, like other countries, does occasionally intervene. Therefore, the U.S. currency pol- icy is best described as a managed floating rate system.

The value of a country’s currency depends on many factors, includ- ing the imports and exports of goods and services. As the demand and supply of countries’ currencies rises and falls, the exchange rates, which reflect the currencies’ relative values, change if rates are allowed to “float.” For example, if a Swiss company purchases U.S. goods, the Swiss company must buy U.S. dollars to purchase the goods, thus creat- ing demand for U.S. dollars. If a U.S. company purchases Swiss goods, the U.S. company must buy Swiss francs, thus creating demand for Swiss francs. If there is increased demand for U.S. dollars, the price of the dol- lar relative to the Swiss franc increases—the U.S. dollar appreciates and

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the Swiss franc depreciates. But this system does not go unchecked— countries’ central banks may buy or sell currencies to affect the exchange rates, thus managing the rate changes. Usually, the role of the central banks is to smooth out any sudden fluctuations in exchange rates.

Another factor that affects the relative value of currencies is the movement of investment capital from one country to another. If interest rates are higher in one country, investors may buy the currency of that country in order to buy the interest-bearing securities in that country. This shifting of investment capital increases the demand for the cur- rency of the country with the higher interest rate.

When a currency loses value relative to other currencies, we say that the currency has “depreciated” if the change is due to changes in supply and demand, or has been “devalued” if the change is due to government intervention. If the currency gains value relative other currencies, we say that the currency has “appreciated” or been “revalued.”