You must have changed American dollars to a foreign currency at least once in your travels, so you know what the action is about. However, there’s a long way from performing to understanding currency exchange. To use these tools in your business, you need to be familiar with the process and with its advantages and disadvantages. Here is a small guide on what currency exchange is about, and how to apply it in the business environment.
What is currency exchange?
You must be aware of the fact that money is different in every country. You can’t go in a foreign place with a different currency than in your country and buy something using dollars. For that, you will need to exchange your money to the local currency.
Why is an exchange rate important?
However, different currency doesn’t have the same value, so you can’t go to a bank and offer 10 American dollars in exchange of 10 euro. This is where the exchange rate comes into action. In fact, this rate means purchasing one form of currency for a different form of currency. You can either sell or buy a foreign currency, which has a certain price.
These exchange rates do not remain constant. By studying it over the years, you can see how certain currencies have decreased their value. This happened because of inflation, which means that a currency’s capacity to buy certain goods has gone down. This fluctuation occurs as we speak, and the value of a currency can change from one day to another.
How to read an exchange rate
You can buy or sell a currency every day, at any hour, at the current value of the day. This cycle implies two currencies, as you sell one in exchange for another. Therefore, you get a currency pair, and the exchange rate is made of these two currencies. In the case of American dollars and euro, the exchange rate is USD/EUR.
Right after these pairs, there is a number. This number represents the amount of euros needed to buy an American dollar. The first currency in the pair is always equal to one unit in the pair. The listed number is the exchange rate from the first currency to the second. By diving 1 to this exchange rate, you’ll get how much euros one dollar is worth.
As an example, the current USD/EUR exchange rate is 0.805879698. Therefore, for 1 American dollar, you have to pay 0.805879698 euros.
Understanding currency exchange in business
If you want to trade foreign currency, you need to choose your strategies and make sure you don’t invest at a loss. Understanding currency exchange is not that difficult, but it’s essential in business. First of all, you need to settle on the exchange rate you’ll use.
Spot rates and forward rates
You can choose to do business at a spot rate or forward rate. The spot rate is the current exchange rate, while the forward rate is an exchange at a future rate. You can agree on a specific future rate, over a fixed period of time.
This comes into action whenever you’re trading with foreign companies. In some cases, you might have agreed to purchase some goods from a company in a different country. However, the agreement might be to purchase the goods over a period of 30 days, at that future exchange rate. This is both good and bad. You can either pay fewer money on these goods, or end up having to pay a lot more.
Fortunately, there are solutions to such a problem. To protect your business from the future, you can adopt a technique called hedging. This consists of a contract which locks in a certain exchange rate from your currency to the other. This way, you can be sure about the amount of money you’ll have to spend, and can manage the situation better.
However, it might be better to trade with foreign companies at a spot rate. However, this can only be possible with payments you can make on the spot, and affairs that require immediate action. In other cases, you can still take some precautions. For instance, install a limit order.
Limit orders and stop losses
A limit order means that you are willing to make a transaction at a specified exchange rate limit. Whenever your target currency reaches that limit, you can perform the transaction. This way, you can avoid paying too much money because the exchange rate has increased.
Another effective method of protection is to establish a stop loss. This is an effective way to stop yourself from losing capital by establishing another limit. This time, the limit represents the biggest amount of money you are willing to lose in a trade. If the exchange rate gets too high and might result in too many losses, the system will automatically perform the transaction.
In the end, you can have a combination of these two. This is called an OCO Order, where OCO stands for One Cancels the Other. You can activate both a limit order and a stop loss, but you should also activate an OCO Order. This way, whenever one of the first two comes into action, the OCO Order cancels the second one automatically.
This is an effective method to let your trade be free. Once you choose the upper and lower limit you agree to, your currency can fluctuate anywhere between these two.
What to know before starting the business
This is just a basic lesson on understanding currency exchange. However, if you want to make sure everything goes fine, you might want to consult an expert. He can understand the market way better than you and make some observations. Then, based on these observations, he can guide you and give you valuable advice.
Understanding currency exchange is not that difficult, but it’s important to have a good grasp on the concepts before starting any kind of business. Instead of looking at the concepts superficially and then making mistakes which cost you money, it’s better to study the matter thoroughly.