18.1 Exchange Rates

Doing business across national borders requires the use of different national currencies. An international trade transaction usually involves two separate purchases. For instance, if foreigners were interested in buying Canadian products, they would likely first buy Canadian dollars and then use these Canadian dollars to pay for the Canadian products. Foreigners obtain (and dispose of) Canadian dollars in the foreign exchange market, where different national currencies are traded. The foreign exchange market determines the prices at which currencies exchange for each other, i.e., exchange rates.

The foreign exchange market is very large (in excess of USD5 trillion per day) and most foreign exchange transactions involve the U.S. dollar. USD dominates the foreign exchange market with 88.3% trade in 2019 and 88.5% trade of all foreign exchange transactions in 2022. The U.S. dollar is followed by euro and Japanese yen in 2022. Table 18.1 shows the top 10 most traded currencies on foreign exchange markets in 2019 and 2022.

Table 18.1 indicates that exporters, importers, investors, visitors etc. mostly exchange their currencies with USD. The rate at which a currency is exchanged with another currency is known as its exchange rate. In other words, the exchange rate is a price — it is the price of one currency expressed in terms of units of another currency such as £1 exchanging for USD 1.50 and CAD 1 exchanging for 61 INR. Exchange rates are expressed in two ways, one being the reciprocal of the other. If the exchange value of £1 is USD1.50, the exchange value of the USD is £0.67. If a currency’s exchange value is rising, this suggests demand for that currency is relatively strong. The converse is also true. The interaction of demand for and supply of a currency determine the exchange rate. When supply is equal to demand in the foreign exchange market, the equilibrium exchange rate is determined.

Calculating Exchange Rate

The costs to companies are impacted when the prices of the raw materials they use change. Very little coffee is grown in the United States. This means that all the coffee beans that Starbucks uses in its espresso machines in Seattle, New York, Miami, and Houston were bought from suppliers outside of the United States. Brazil is the largest coffee-producing country, exporting about one-third of the world’s coffee (Barros, 2019). When a company purchases raw materials from a supplier in another country, the company needs not just money but the money that is used in that country to make the purchase. Thus, the company is concerned about the exchange rate, or the price of the foreign currency.

The currency used in Brazil is called the Brazilian real. In March 2021, 5.4377 Brazilian reals could be purchased for $1.00.^[1] This will often be written in the form of

[latex]\text{USD 1} = \text{BRL 5.4377}[/latex]

BRL is an abbreviation for the Brazilian real, and USD is an abbreviation for the U.S. dollar. This price is known as a currency exchange rate, or the rate at which you can exchange one currency for another currency.

If you know the price of $1.00 is 5.4377 Brazilian reals, you can easily find the price of Brazilian reals in U.S. dollars. Simply divide both sides of the equation by 5.4377, or the price of the U.S. dollar:

[latex]\text{USD 1} = \text{BRL 5.4377}[/latex]

[latex]\frac{{\text{USD 1}}}{5.4377} = \frac{{\text{BRL 5.4377}}}{5.4377}[/latex]

If you have U.S. dollars and want to purchase Brazilian reals, it will cost you $0.1839 for each Brazilian real you want to buy.

The foreign exchange rate changes in response to demand for and supply of the currency. In early 2020, the exchange rate was USD 1=BRL 4. In other words, $1 purchased fewer reals in early 2020 than in it did a year later. Because you receive more reals for each dollar in 2021 than you would have a year earlier, the dollar is said to have appreciated relative to the Brazilian real. Likewise, because it takes more Brazilian reals to purchase $1.00, the real is said to have depreciated relative to the U.S. dollar.

References

Barros, S. (2019, May). Brazil: Coffee annual 2019. GAIN report no. BR19006 [PDF]. Global Agricultural Information Network. USDA Foreign Agricultural Service. https://apps.fas.usda.gov/newgainapi/api/report/downloadreportbyfilename?filename=Coffee%20Annual_Sao%20Paulo%20ATO_Brazil_5-16-2019.pdf

Attributions

“Calculating Exchange Rate” is adapted from “20.3 Exchange Rates and Risk” from Principles of Finance by OpenStax – Rice University and is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted. Access “Principles of Finance” for free.