You don’t need to know how to detect triangular arbitrage or understand interest rate parity and forward pricing to become familiar with basics of currency exchange. At a fundamental level it is quite simple.
Its intrinsically a matter of supply and demand. The concept is pretty straightforward. If supply of a good exceeds demand, the price will go down. If demand exceeds supply, the price will go up. A perfect illustration is the automobile industry. In the 1990’s demand for SUV’s skyrocketed. Dealers could not keep models like Jeep Cherokees and Chevy Tahoes on the lot. The prices of those vehicles soared. Fast forward to somewhere around 2003. Rising gas prices and a reversion to environmental consciousness, led to a dramatic decrease in demand so prices plunged. The same idea can be applied to most any product or service.
Now, back to currency. Look at it like this. Currency is just another product driven by supply and demand. The price, or value, of a specific currency is expressed as an exchange rate. An exchange rate is the amount of one currency that it costs to purchase 1 unit of another currency.
The currency we are all most familiar with is the dollar, so we will use that as the ongoing example of how currency exchange works. The dollar has different exchange rates with different currencies all over the world and they change daily. So what exactly does it mean when the media says the dollar is rising or falling? The direction of the dollar on the whole is determined by looking at how the dollar has changed versus all the currencies it is valued against on a trade weighted basis. In other words it’s just a formula that is kind of complicated and not really necessary to know the details of. You just really need to understand that the dollar isn’t valued overall by being positioned against just one other currency. It can rise against the Yen at the same time as it falls against the Euro or the Pound. If the dollar value collectively declines, it is said to be weakening. Conversely, if the value increases, it is strengthening.
But what drives the exchange rate for the dollar? What strengthens or weakens the dollar? It is significantly driven by supply and demand. When you are traveling to Europe and you convert your dollars to euros. You are supplying the dollar and demanding the euros. If more dollars are converted to euros than euros are converted to dollars, the value of the dollar will fall against the euro. This is obviously an oversimplification because currency prices are not primarily driven by tourists converting their fun money for their summer vacations.
So let’s look at the bigger picture. When a country imports goods, how does it pay for them? You got it, with its own currency. If you are a Chinese company, you want to be paid in yuan. So when a US company buys your goods, it needs to take its dollars, exchange them for yuan, and complete the purchase. So, when a country imports goods, it decreases the value of its domestic currency. Exports, on the other hand, increase it.
Let’s look at how a weakening dollar can affect a US company. A falling dollar can cripple an American based business that relies significantly on foreign imports. For example, let’s say American Toy Company needs to import purple buttons to use as eyes for a teddy bear that is going to be assembled in the US. The order is placed 3 months before anticipated delivery from a Japanese company that produces the buttons. The American Toy Company contracts to pay a certain amount of Yen for the buttons that will be delivered in 3 months. In the time between the contract and delivery, the value of the dollar could fall against the yen and therefore could cost the American Toy Company a significant amount more and reduce or eliminate any profit margin built in after the final completed teddy bear is sold. The American Toy Company has several options to protect its margin. The first option would be to raise the price of the final product and have the consumer offset the difference. That strategy presents a problem because they would chance pricing themselves out of range of other teddy bear manufacturers and not being able to sell enough bears to turn a profit. Another option would be to use currency futures to protect themselves from the dollar falling against the yen.
There are several strategies that can be used to do that. The most simple is to purchase enough yen futures to cover the delivery at a dollar value 3 months out. The privilege of being able to assure that American Toy Company can have access to yen at values close to where they are when the contract is negotiated costs them a premium. That premium can be offset by selling dollar futures based on the way they think the dollar will go in the coming months.
Trading strategies for currency futures is another topic for another time. The most important concept to get out of this, today, is that currency values are relative, are substantially driven by supply and demand, and that the strength or weakness of a currency has implications that span all realms of the economy.