How Can Financial Gains Be Made From Foreign Exchange Exposure?

Transactions that involve an exchange of currencies, such as those executed in international trade, comprise a dimension of risk called foreign exchange exposure. A domestic price may be quoted in a foreign currency based on a current exchange rate. Due to the constantly fluctuating nature of exchange rates, the price quoted in the foreign currency may have changed in value at the time of the actual payment and delivery. The risk of concern is that the exchange rate will drop and result in a loss. Conversely, the exchange rate may rise and result in a gain.

Foreign Exchange

• The foreign exchange market is the virtual international venue for the purchase and sale of the world's currencies in exchange for one another. Currency exchange rates, or exchange rates, are the prices at which currencies are exchanged. As with any market, exchange rates fluctuate by both wide and narrow margins depending on the levels of supply and demand. Since it is always daytime somewhere in the world, currencies are traded on a continuous basis -- though not all at once -- and exchange rates continually readjust to accommodate such trading activity.

Exchange Rates

• As the effective "prices of money," exchange rates are formulated between any two currencies, called a currency pair. Each currency in a currency pair has a market value that may be expressed in terms of the value of the other currency. This number is the exchange rate, and its reciprocal value (one divided by the exchange rate) represents the exchange rate based on the second currency. Fluctuations in the market value of either currency precipitate an automatic change in the exchange rate. To illustrate, if both currencies in a given pair bore exactly the same market value, the exchange rate would be 1.00.

Risk Exposure: Losses

• Similar to the purchase and sale of stocks in the stock market, purchases and sales of currency in the foreign exchange market expose the party trading to the risk that they will lose value due to price fluctuations. Since the foreign exchange market is a necessary agent in any exchange involving different currencies, the parties participating in such an exchange are each exposed to foreign exchange risk. An upward change in the applicable exchange rate means a loss for the seller because the seller will need to convert, or repatriate, the buyer's foreign currency back into the domestic currency.

Risk Exposure: Gains

• Just as the risk exposure in the foreign exchange market can result in losses, it can also result in gains. In an exchange involving two different currencies, the selling party will experience a gain in the event that the applicable exchange rate declines between the time that the foreign buyer's price is quoted and the time of the actual transaction.

Example

• To illustrate how foreign exchange exposure can result in gains, suppose that on January 1 a company in the U.K. quotes the price for a 1,000-pound product to a U.S. client for $1,500 based on the exchange rate for that day ($1.50 per one pound). The client decides to actually purchase the item on January 5, and the exchange rate on this day is $1.40 per one pound. The company in the U.K. repatriates the $1,500 back into pounds at the reciprocal rate (0.71 pounds per one dollar) and gets 1,071 pounds, making a gain of 71 pounds ($1,500 x 0.71 pounds per one dollar).