Foreign Exchange 101 - Understanding the FX Market
Author: Matthew Burke, Senior Advisor, International Banking
Due to the risks associated with dealing in foreign currencies, some businesses may avoid international trade. However, confining your business only to local markets may open your company up to other risks by limiting business competitiveness and opportunities for growth.
The good news is that there are ways to successfully navigate cross border payments and the foreign exchange market. Here are some tips to help you succeed.
Understanding the Foreign Exchange Market and What It Means for Your Business
When conducting business abroad, the companies involved in the transaction must decide on a mutually accepted currency. Businesses are free to select any number of currencies but will usually opt to use a home currency for one of the companies involved in the transaction.
For example, an agricultural exporter selling wheat to Mexico may opt to conduct the transaction in pesos. To do so, the exporter will accept payment in Mexican Pesos then will convert the payment to U.S. dollars on the foreign exchange (FX) market.
What is the FX Market?
The FX market is an over the counter marketplace where currencies are bought, sold and exchanged. It is the world’s largest over the counter marketplace, trading an average daily turnover of approximately 5.1 trillion U.S. dollars in 2019.
Currency on the FX market is exchanged in pairs. For instance, our U.S. exporter selling wheat to Mexico has found it advantageous to price goods using the Mexican peso. In this instance, the peso and the U.S. dollar make up the currency pair.
The exchange rate indicates the market price to convert one currency (Mexican pesos) to another (U.S. dollars). There are many factors that make exchange rates fluctuate, including monetary policy, interest rates and the strength of an economy. A strong U.S. dollar, for example, would trade at a higher value than the purchasing currency. For that reason, a strong dollar is excellent for any U.S. company that imports goods like raw materials, or finished goods like electronics, because the U.S. company needs to spend less to purchase the same amount of product.
Conversely, a weak dollar is advantageous for U.S. exporters, like manufacturers or farmers who sell grain overseas. With a weak dollar, U.S. exports seem more competitively priced from an international cost perspective.
Currency spreads indicate the difference between the market rate and the actual exchange rate. While it may seem counterintuitive, the exchange rate is not a fixed number for a given time. Instead, it can fluctuate based on the overall volume of currency the exporter has sent over time and their relationship with their international bank and exchange provider.
For this reason, and many others, it’s a good idea to work with a local financial institution on currency exchanges.
How Your Bank Can Help Facilitate Foreign Currency Exchanges
Working with your bank to convert funds is usually the easiest approach to convert foreign currency, particularly if the bank is the one initiating payment through a wire transfer. Considering that banks are regulated by government agencies and are required to have sufficient capital and access to liquidity, converting currency through a bank is also deemed safe.
Working with your financial institution has other advantages as well. Many companies find that pricing exports in a foreign currency makes them more competitive against local competition because it gives the buyer an “apples to apples” comparison of costs. But pricing this way also creates the risk that future fluctuations in currency value could erode some or all of the profit margin. Your bank is there to partner with you on risk mitigation strategies, such as forward contracts, to help reduce currency risk and make the most of your foreign trade opportunities.
Creating an Internal FX Risk Management Policy
Establishing an internal FX risk management policy is something that is recommended when doing business internationally. In particular, when you begin using hedging tools to manage risk associated with your overseas exposure, creating a risk management policy that designates the following can be a helpful exercise:
- What regions and/or products are a potential risk?
- What person or department is responsible for managing those risks?
- What tools will be utilized to manage the risk?
- How is a successful risk management policy going to be measured internally?
If you’re looking for guidance when it comes to doing business internationally or managing your FX risk, FNBO’s Global Banking team can help. Our team combines knowledge of the field, intuitive technology and a consultative approach to bring you simple, cost-effective solutions for navigating the global finance scene. Learn more.
About the Author
Matt has been in commercial banking since 2006. His experience in the Global Banking Group and Commercial Credit Analysis has given him a wide depth of knowledge in assisting clients reach their financial goals. As a member of the Global Banking team, Matt has an extensive knowledge of the foreign exchange markets, international payment options, international trade products and letters of credit.
The articles in this blog are for informational purposes only and not intended to provide specific advice or recommendations. When making decisions about your financial situation, consult a financial professional for advice. Articles are not regularly updated, and information may become outdated.