Definition: A foreign exchange rate is the price of the domestic currency stated in terms of another currency. In other words, a foreign exchange rate compares one currency with another to show their relative values. Since standardized currencies around the world float in value with demand, supply, and consumer confidence, their values change relative to each over time. For instance, one US dollar in 2011 was worth about .68 Euros. In 2014, one US dollar is worth .75 Euros. This means the dollar has increased in value over this three-year span, but the Euro is still 25% more valuable.
What Does Foreign Exchange Rate Mean?
Since companies are developing increasingly larger international ties and investors, currency rate changes can affect different markets investing power drastically. Investors need to know how their investment will change with changes in their currency. Multi-national companies typically have one reporting currency that they prepare all of their financial statements in. US companies, for example, are required to produce a balance sheet and income statement along with other reports in US dollars.
They do, however, make special statements that report in other currencies. Companies like Nike and McDonald’s produce multiple financial statements converted in different currencies for investors around the world.
Example
The foreign exchange rate also plays a role in recording some business events between multi-national businesses. Take a US based manufacturer for example. It might contract out some of its work to companies in Japan that only sell goods in Yen. Since the US company can’t record the purchases in Yen, it must convert the purchase price from Yen to US dollars in order to enter it into the accounting system.
There are also inherent risks with transactions like this. What happens when the US company signs a contract to purchase the goods in Yen, but before the payment is issued the US dollar declines compared to the Yen? The US company would have to pay more for the goods. That’s what investment puts and hedges are important when dealing in different currencies.
