Exchange Rates

An Exchange Rate (also known as a Forex Rate or FX Rate) is simply the price of one country's currency in terms of another. Think of it as a price tag. If the exchange rate between the Euro and the US Dollar (EUR/USD) is 1.10, it means that one Euro costs one dollar and ten cents. This pricing happens in the massive, decentralized Foreign Exchange Market (Forex), where trillions of dollars' worth of currencies are traded daily. When you see a rate like EUR/USD, it's called a Currency Pair. The first currency (EUR) is the Base Currency—it's the 'thing' being bought or sold. The second currency (USD) is the Quote Currency—it's the price you pay. So, EUR/USD = 1.10 means you need $1.10 to buy €1. Understanding this simple price mechanism is the first step to seeing how global economies and your international investments are connected.

Imagine each country is a publicly traded company, and its currency is its stock. When you “buy” a currency—say, by exchanging your dollars for Swiss Francs—you are essentially making a bet on the health and stability of the Swiss economy. If Switzerland's “company” performs well (strong economy, stable politics), more people will want to own its “stock” (the Franc), driving up its price. If its prospects dim, investors will sell, and the price will fall. This “country as a company” analogy helps cut through the complexity. At its heart, a currency's long-term value reflects the world's confidence in that country's economic future.

Currency prices aren't static; they bounce around every second. While short-term moves can be driven by noise and speculation, a value investor focuses on the fundamental drivers.

These are the primary forces that governments and their banks use, which have a profound impact on currency value.

• Interest Rates: This is a big one. Central Banks, like the US Federal Reserve or the European Central Bank, set their nation's core interest rate. Higher interest rates offer lenders a better return. As a result, global capital flocks to countries with higher rates to earn more on their money, increasing demand for that country's currency and strengthening it.
• Inflation: Inflation erodes the purchasing power of money. If a country has high and rising inflation, each unit of its currency buys fewer goods and services. Naturally, this makes the currency less attractive, causing its value to fall relative to currencies from countries with lower inflation. The theory of Purchasing Power Parity (PPP) suggests that, over the long run, exchange rates should move towards a level that would make a basket of goods (like a Big Mac) cost the same in any two countries.

Just like a company, a country's performance is constantly being graded by the market.

• Economic Health: Strong economic growth, low unemployment, and a stable political environment inspire confidence. A robust economy attracts foreign investment, boosting the currency's value.
• Balance of Payments: This is a record of all transactions between a country and the rest of the world. A country with a consistent surplus (more money flowing in from exports and investments than flowing out) will typically see its currency appreciate, as foreigners need to buy its currency to pay for its goods.

For investors who stick to their home market, exchange rates might seem like a distant concern. But for anyone owning international stocks or funds, they are a critical and often overlooked component of returns.

When you buy a foreign stock, you are making two bets: one on the company and one on the currency.

• Example: Let's say you, an American investor, buy shares in a German company for €1,000.
  1. At the time of purchase, the exchange rate is EUR/USD = 1.10. Your investment costs you $1,100 (€1,000 x 1.10).
  2. A year later, the stock has risen 10% to €1,100. Great! But during that year, the Euro also strengthened against the dollar, and the new exchange rate is EUR/USD = 1.20.
  3. When you sell your shares for €1,100, they are now worth $1,320 (€1,100 x 1.20).
  4. Your original $1,100 investment turned into $1,320, a gain of $220. That's a 20% return in dollar terms! The 10% stock gain was supercharged by an additional 10% currency gain. Of course, if the Euro had weakened, it would have eaten into your returns.

Exchange rates directly impact a company's sales and profits. Understanding this can reveal strengths and weaknesses in its business model.

• For Exporters: A weak home currency is a gift. If the US dollar weakens, a company like Boeing, which sells planes in dollars, finds its products become cheaper for foreign buyers, potentially boosting sales.
• For Importers: A strong home currency is a benefit. A British retailer that imports clothing from Asia loves a strong Pound because its purchasing power increases, lowering its costs.
• The Takeaway: Analyzing a company's currency exposure is a key part of understanding its competitive advantages, or Economic Moat. Is the business resilient enough to withstand unfavorable currency swings?

Trying to predict short-term currency movements is a speculator's game, not an investor's. The Forex market is notoriously volatile and complex. For a value investor, the lesson isn't to become a currency trader. Instead, the goal is to be aware of currency risk. When you buy a piece of a wonderful business abroad, understand that the exchange rate is a powerful variable that can affect your ultimate return. It's one more piece of the puzzle to consider in your quest for long-term value.