7.1 What Do We Mean by Currency and Foreign Exchange?

Currency Conversion

Companies, investors, and governments want to be able to convert one currency into another. A company’s primary purposes for wanting or needing to convert currencies is to pay or receive money for goods or services. Imagine you have a business in the United States that imports wines from around the world. You’ll need to pay the French winemakers in euros, your Australian wine suppliers in Australian dollars, and your Chilean vineyards in pesos. Obviously, you are not going to access these currencies physically. Rather, you’ll instruct your bank to pay each of these suppliers in their local currencies. Your bank will convert the currencies for you and debit your account for the US dollar equivalent based on the exact exchange rate at the time of the exchange.

Currency Hedging

One of the biggest challenges in foreign exchange is the risk of rates increasing or decreasing in greater amounts or directions than anticipated. Currency hedging refers to the technique of protecting against the potential losses that result from adverse changes in exchange rates. Companies use hedging as a way to protect themselves if there is a time lag between when they bill and receive payment from a customer. Conversely, a company may owe payment to an overseas vendor and want to protect against changes in the exchange rate that would increase the amount of the payment. For example, a retail store in Japan imports or buys shoes from Italy. The Japanese firm has ninety days to pay the Italian firm. To protect itself, the Japanese firm enters into a contract with its bank to exchange the payment in ninety days at the agreed-on exchange rate. This way, the Japanese firm is clear about the amount to pay and protects itself from a sudden depreciation of the yen. If the yen depreciates, more yen will be required to purchase the same euros, making the deal more expensive. By hedging, the company locks in the rate.

Currency Arbitrage

Arbitrage is the simultaneous and instantaneous purchase and sale of a currency for a profit. Advances in technology have enabled trading systems to capture slight differences in price and execute a transaction, all within seconds. Previously, arbitrage was conducted by a trader sitting in one city, such as New York, monitoring currency prices on the Bloomberg terminal. Noticing that the value of a euro is cheaper in Hong Kong than in New York, the trader could then buy euros in Hong Kong and sell them in New York for a profit. Today, such transactions are almost all handled by sophisticated computer programs. The programs constantly search different exchanges, identify potential differences, and execute transactions, all within seconds.

Currency Speculation

Speculation refers to the practice of buying and selling a currency with the expectation that the value will change and result in a profit. Such changes could happen instantly or over a period of time.

High-risk, speculative investments by nonfinance companies are less common these days than the current news would indicate. While companies can engage in all four uses discussed in this section, many companies have determined over the years that arbitrage and speculation are too risky and not in alignment with their core strategies. In essence, these companies have determined that a loss due to high-risk or speculative investments would be embarrassing and inappropriate for their companies.

How to Quote a Currency

There are several ways to quote currency, but let’s keep it simple. In general, when we quote currencies, we are indicating how much of one currency it takes to buy another currency. This quote requires two components: the base currency and the quoted currency. The quoted currency is the currency with which another currency is to be purchased. In an exchange rate quote, the quoted currency is typically the numerator. The base currency is the currency that is to be purchased with another currency, and it is noted in the denominator. For example, if we are quoting the number of Hong Kong dollars required to purchase 1 US dollar, then we note HKD 8 / USD 1. (Note that 8 reflects the general exchange rate average in this example.) In this case, the Hong Kong dollar is the quoted currency and is noted in the numerator. The US dollar is the base currency and is noted in the denominator. We read this quote as “8 Hong Kong dollars are required to purchase 1 US dollar.” If you get confused while reviewing exchanging rates, remember the currency that you want to buy or sell. If you want to sell 1 US dollar, you can buy 8 Hong Kong dollars, using the example in this paragraph.

Direct Currency Quote and Indirect Currency Quote

Additionally, there are two methods—the American terms and the European terms—for noting the base and quoted currency. These two methods, which are also known as direct and indirect quotes, are opposite based on each reference point. Let’s understand what this means exactly.

The American terms, also known as US terms, are from the point of view of someone in the United States. In this approach, foreign exchange rates are expressed in terms of how many US dollars can be exchanged for one unit of another currency (the non-US currency is the base currency). For example, a dollar-pound quote in American terms is USD/GP (US$/£) equals 1.56. This is read as “1.56 US dollars are required to buy 1 pound sterling.” This is also called a direct quote, which states the domestic currency price of one unit of foreign currency. If you think about this logically, a business that needs to buy a foreign currency needs to know how many US dollars must be sold in order to buy one unit of the foreign currency. In a direct quote, the domestic currency is a variable amount and the foreign currency is fixed at one unit.

Conversely, the European terms are the other approach for quoting rates. In this approach, foreign exchange rates are expressed in terms of how many currency units can be exchanged for a US dollar (the US dollar is the base currency). For example, the pound-dollar quote in European terms is £0.64/US$1 (£/US$1). While this is a direct quote for someone in Europe, it is an indirect quote in the United States. An indirect quote states the price of the domestic currency in foreign currency terms. In an indirect quote, the foreign currency is a variable amount and the domestic currency is fixed at one unit.

A direct and an indirect quote are simply reverse quotes of each other. If you have either one, you can easily calculate the other using this simple formula:

direct quote = 1 / indirect quote.

To illustrate, let’s use our dollar-pound example. The direct quote is US$1.56 = 1/£0.64 (the indirect quote). This can be read as

1 divided by 0.64 equals 1.56.

In this example, the direct currency quote is written as US$/£ = 1.56.

While you are performing the calculations, it is important to keep track of which currency is in the numerator and which is in the denominator, or you might end up stating the quote backward. The direct quote is the rate at which you buy a currency. In this example, you need US$1.56 to buy a British pound.

Tip: Many international business professionals become experienced over their careers and are able to correct themselves in the event of a mix-up between currencies. To illustrate using the example mentioned previously, the seasoned global professional knows that the British pound is historically higher in value than the US dollar. This means that it takes more US dollars to buy a pound than the other way around. When we say “higher in value,” we mean that the value of the British pound buys you more US dollars. Using this logic, we can then deduce that 1.56 US dollars are required to buy 1 British pound. As an international businessperson, we would know instinctively that it cannot be less—that is, only 0.64 US dollars to buy a British pound. This would imply that the dollar value was higher in value. While major currencies have changed significantly in value vis-à-vis each other, it tends to happen over long periods of time. As a result, this self-test is a good way to use logic to keep track of tricky exchange rates. It works best with major currencies that do not fluctuate greatly vis-à-vis others.

A useful side note: traders always list the base currency as the first currency in a currency pair. Let’s assume, for example, that it takes 85 Japanese yen to purchase 1 US dollar. A currency trader would note this as follows: USD 1 / JPY 85. This quote indicates that the base currency is the US dollar and 85 yen are required to purchase a dollar. This is also called a direct quote, although FX traders are more likely to call it an American rate rather than a direct rate. It can be confusing, but try to keep the logic of which currency you are selling and which you are buying clearly in your mind, and say the quote as full sentences in order to keep track of the currencies.

These days, you can easily use the Internet to access up-to-date quotes on all currencies, although the most reliable sites remain the Wall Street Journal, the Financial Times, or any website of a trustworthy financial institution.

Spot Rates

The exchange rates discussed in this chapter are spot rates—exchange rates that require immediate settlement with delivery of the traded currency. “Immediate” usually means within two business days, but it implies an “on the spot” exchange of the currencies, hence the term spot rate. The spot exchange rate is the exchange rate transacted at a particular moment by the buyer and seller of a currency. When we buy and sell our foreign currency at a bank or at American Express, it’s quoted at the rate for the day. For currency traders though, the spot can change throughout the trading day even by tiny fractions.

To illustrate, assume that you work for a clothing company in the United States and you want to buy shirts from either Malaysia or Indonesia. The shirts are exactly the same; only the price is different. (For now, ignore shipping and any taxes.) Assume that you are using the spot rate and are making an immediate payment. There is no risk of the currency increasing or decreasing in value. (We’ll cover forward rates in the next section.)

The currency in Malaysia is the Malaysian ringgit, which is abbreviated MYR. The supplier in Kuala Lumpur e-mails you the quote—you can buy each shirt for MYR 35. Let’s use a spot exchange rate of MYR 3.13 / USD 1.

The Indonesian currency is the rupiah, which is abbreviated as Rp. The supplier in Jakarta e-mails you a quote indicating that you can buy each shirt for Rp 70,000. Use a spot exchange rate of Rp 8,960 / USD 1.

It would be easy to instinctively assume that the Indonesian firm is more expensive, but look more closely. You can calculate the price of one shirt into US dollars so that a comparison can be made:

For Malaysia: MYR 35 / MYR 3.13 = USD 11.18
For Indonesia: Rp 70,000 / Rp 8,960 = USD 7.81

Indonesia is the cheaper supplier for our shirts on the basis of the spot exchange rate.

Cross Rates

There’s one more term that applies to the spot market—the cross rate. This is the exchange rate between two currencies, neither of which is the official currency in the country in which the quote is provided. For example, if an exchange rate between the euro and the yen were quoted by an American bank on US soil, the rate would be a cross rate.

The most common cross-currency pairs are EUR/GBP, EUR/CHF, and EUR/JPY. These currency pairs expand the trading possibilities in the foreign exchange market but are less actively traded than pairs that include the US dollar, which are called the “majors” because of their high degree of liquidity. The majors are EUR/USD, GBP/ USD, USD/JPY, USD/CAD (Canadian dollar), USD/CHF (Swiss franc), and USD/AUD (Australian dollar). Despite the changes in the international monetary system and the expansion of the capital markets, the currency market is really a market of dollars and nondollars. The dollar is still the reserve currency for the world’s central banks. Table 7.1 “Currency Cross Rates” contains some currency cross rates between the major currencies. We can see, for example, that the rate for the cross-currency pair of EUR/GBP is 1.1956. This is read as “it takes 1.1956 euros to buy one British pound.” Another example is the EUR/JPY rate, which is 0.00901. However, a seasoned trader would not say that it takes 0.00901 euros to buy 1 Japanese yen. He or she would instinctively know to quote the currency pair as the JPY/EUR rate or—more specifically—that it takes 111.088 yen to purchase 1 euro.

Forward Rates

The forward exchange rate is the exchange rate at which a buyer and a seller agree to transact a currency at some date in the future. Forward rates are really a reflection of the market’s expectation of the future spot rate for a currency. The forward market is the currency market for transactions at forward rates. In the forward markets, foreign exchange is always quoted against the US dollar. This means that pricing is done in terms of how many US dollars are needed to buy one unit of the other currency. Not all currencies are traded in the forward market, as it depends on the demand in the international financial markets. The majors are routinely traded in the forward market.

For example, if a US company opted to buy cell phones from China with payment due in ninety days, it would be able to access the forward market to enter into a forward contract to lock in a future price for its payment. This would enable the US firm to protect itself against a depreciation of the US dollar, which would require more dollars to buy one Chinese yuan. A forward contract is a contract that requires the exchange of an agreed-on amount of a currency on an agreed-on date and a specific exchange rate. Most forward contracts have fixed dates at 30, 90, or 180 days. Custom forward contracts can be purchased from most financial firms. Forward contracts, currency swaps, options, and futures all belong to a group of financial instruments called derivatives. In the term’s broadest definition, derivatives are financial instruments whose underlying value comes from (derives from) other financial instruments or commodities—in this case, another currency.

Swaps, Options, and Futures

Swaps, options, and futures are three additional currency instruments used in the forward market.

A currency swap is a simultaneous buy and sell of a currency for two different dates. For example, an American computer firm buys (imports) components from China. The firm needs to pay its supplier in renminbi today. At the same time, the American computer is expecting to receive RMB in ninety days for its netbooks sold in China. The American firm enters into two transactions. First, it exchanges US dollars and buys yuan renminbi today so that it can pay its supplier. Second, it simultaneously enters into a forward contract to sell yuan and buy dollars at the ninety-day forward rate. By entering into both transactions, the firm is able to reduce its foreign exchange rate risk by locking into the price for both.

Currency options are the option or the right—but not the obligation—to exchange a specific amount of currency on a specific future date and at a specific agreed-on rate. Since a currency option is a right but not a requirement, the parties in an option do not have to actually exchange the currencies if they choose not to. This is referred to as not exercising an option.

Currency futures contracts are contracts that require the exchange of a specific amount of currency at a specific future date and at a specific exchange rate. Futures contracts are similar to but not identical to forward contracts.