101: Exchange Rates Part II


In our previous Exchange Rates Part I post, we gave an overview of the way that currency markets operate and explained the importance of foreign exchange rates to many small business owners in today’s global economy.  Now let’s take an in-depth look at some of the specific ways that exchange rates can affect your business and propose some solutions to dealing with this somewhat-complex issue.

We’ll begin by looking at things from the point of view of a business owner who is dependent upon an overseas supplier for some or all of his raw materials or services.  In our example we’ll assume that the business owner is located in the U.S. and has a company that makes wool sweaters. He has determined that he prefers to buy wool from a provider in New Zealand, where the sheep are plentiful and the quality is excellent, and has agreed upon a price per pound of wool in U.S. Dollars that is profitable for his business.  Things are moving along smoothly for a while but a few months later when he goes to place his next order he discovers that his supplier is charging 10% more for the same amount of wool.  What happened?

While there could be a number of reasons for the price increase, for our example we’re going to assume that is was entirely driven by a change in the exchange rate between the U.S. dollar and the New Zealand dollar (affectionately dubbed the “kiwi” by currency traders).  Specifically what has happened is that the U.S. dollar has lost 10% of its value versus the Kiwi.  And while our sweater-maker has always paid for his purchases in U.S. dollars, what he may not have realized is that those dollars aren’t much good to someone living in New Zealand.  Therefore his supplier must convert those U.S. dollars into New Zealand dollars, and because of the fall in the value of the U.S. dollar the supplier now needs 10% more U.S. dollars per pound of wool in order to maintain his same level of profitability.

Now let’s think about what happens when our sweater-maker goes to sell his products to customers around the world via his online store.  He sets all of his prices in U.S. dollars but sells his products to customers who earn their livings in any number of different currencies.  Thus if the price of the U.S. dollar falls relative to the home currencies of some of his customers, his products will essentially become cheaper for them, but if the price of the U.S. dollar rises against some other customers’ home currencies, his products will seem more expensive to them.

So how is a small business owner supposed to manage the effects that currency rates can have on both his purchases and sales?  The most important thing to do is to stay informed of the level and direction of the exchange rates that matter to your business (i.e. those of the countries that you buy from or sell to).

If you find that a weaker U.S. dollar is driving up the price that you have to pay to foreign suppliers you may want to look for alternative suppliers either at home or in countries with a more favorable exchange rate.  And if the U.S. dollar is getting stronger but your foreign suppliers are not adjusting their prices downward, it may be time for you to renegotiate your contracts with the knowledge that your dollars are now worth more than they used to be.  As for the sales side of the equation, it may pay to ramp up your marketing efforts in countries whose currencies have appreciated versus the U.S. dollar, as your products are effectively on sale there without you having to drop the price.  Finally, there is the option to hedge the risk of your exposure to fluctuations in foreign currency via the financial markets, but this is something you would need to discuss with a reputable financial professional with expertise in the field.

More By Gregg Schoenberg
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