Impact of Foreign Exchange Rates on Business

Foreign exchange rates can have a significant impact on the profitability of a business. Learn how exchange rates are determined and how they affect businesses. Discover ways to protect your business from the impact of exchange rate fluctuations. References included.

Foreign exchange rate refers to the rate of one currency in relation to the other. For example, 1
USD is equal to INR 73, this implies that the exchange rate is 73 INR/USD. The exchange rate
moves based on the demand and supply of the currency in the market. The currency that has a
higher demand in the market will see an increasing trend in the prices and the currency that faces
a lower demand would have decreasing trends in prices.
Exchange rate of the currency is also driven by the rate of interest in a country relative to the
other country. The country that has a higher rate of interest would have low exchange rate as
compared to the country that has a lower rate of interest.
Exchange rate can have significant impact on the profitability of the company which deals in the
currency other than the home currency. For example, if an entity is based in USA and is
importing the raw material from Australia, the movement in the rate of exchange between USD
and AUD will impact the profitability of the company. As the company would be earning
revenues in USD and the amount for raw material needs to be settled in AUD, thus, if the AUD
becomes strong, the company would tend to loose money due to exchange rate and thus, the
margins of the company would reduce significantly. On the other hand, if USD becomes strong
the effective cost of imports in AUD for the American company would reduce, leading to the
increase in the profits of the company.
Our firm developed a business model involving manufacturing of components of automobiles in
Japan and exporting them to the US and selling cars, manufactured using those components, in
the US. At the time of evaluation of the proposal, the exchange rate was 115 USD/JPY and based
on the computations made by the management, company was expected to earn a margin of 18%
on the components.
It took 18 months for the company to set up the required manufacturing facilities in Japan, to be
able to manufacture the required components. When the production of the components started,
the dollar appreciated and the exchange rate moved to $ 124 USD/JPY, since the company was
engaged in manufacturing the component in Japan and selling them in the US, the company
gained from the movement in the exchange rate, the difference arising on account of increase in
exchange rate, led to the increase in margin from 18% to 20%.
The company earned the margin of 20% for a period of 6 months, post which dollar became
weak and the exchange rates started falling and dropped to as low as 77 Dollars/JPY and the
margins of the company on the product, dropped significantly, it touched as low as 12%. This
was driven by the falling exchange rate of the two currencies.
The shifts in exchange rates, as explained above, also led to a movement in the quantities of the
vehicles sold by the company, it did fell drastically, owing to the increase in interest rates in the
country, led by the falling exchange rates.

The company can benefit from the movement in the exchange rate, if it is able to predict the
direction of movement of the exchange rate. If the exchange rates are expected to shift to
downside, it would be beneficial for the company to stock the required material with it, so that
the company doesn’t have to pay for the materials at a lowered exchange rate, i.e. effectively
high rates and vice versa.
In order to protect itself from the movements in the exchange rate, the company could opt for
buying futures or options of the currency for a future date, which fixes the amount of cash
outflow for the company, irrespective of the movement in the foreign exchange rate in the
market.
The foreign exchange rates, though are dependent on the demand and supply of a currency in the
market, is also linked to the interest rate on the government bond rate. The rate of exchange of
one currency vis-à-vis another currency, would be dependent on the rate of interest in both the
countries. The country which has higher rate of interest, as compared to the other, would have
lower exchange rate, as compared to the currency of the other country.
References:
Effect of the exchange rate on business (n.d.). Retrieved from
https://www.economicshelp.org/blog/9328/business/effect-exchange-rate-business/. Accessed
on 25 September 2019.
6 factors that influence exchange rates (n.d.). Retrieved from
https://www.investopedia.com/trading/factors-influence-exchange-rates/. Accessed on 25
September 2019.
The relationship between exchange rates, interest rates (n.d.). Retrieved from
https://msu.edu/course/ec/340/Kilic/lecture9.pdf. Accessed on 25 September 2019.