The exchange rate is the rate at which one currency is exchanged for another, at fair, full present value.
There are many levels to understanding how the exchange rate affects individuals (as tourists or investors), businesses that operate in other countries, institutional investors that trade currencies, and the financial health of a country's overarching economy.
Let's start easy. If you're an American planning a trip to Russia, you'll want to know how many rubles you're going to receive for each dollar. Use one of many currency exchange calculators found on the Internet and you might learn (for simplicity's sake) that one dollar will get you two rubles. That's usually a good thing, depending on the purchasing power of each currency. If one dollar will buy you a candy bar and one ruble will buy you a candy bar, you just doubled your candy-buying ability.
Take that to a country-wide level and it would be enticing for America (with the stronger currency) to import Russian goods. But Russia (with the weaker currency) would be less likely to buy goods from America, as the ruble has less purchasing power. However, Russia might get a bump in tourism as Americans realize they can get more for their money over there.
So a weak currency can actually help a country's economy by making its exports cheap. Also, if a company operates in a foreign country with a stronger currency, this can bolster its balance sheet when the foreign currency is converted to the home currency. In the example above, for instance, $100 earned in the U.S. would translate to 200 rubles.
Constantly changing exchange rates are indicators of how well a specific economy is doing. Everyone wants to keep tabs on whether the (insert currency here) is up or down.
What affects exchange rates? It's complicated. Currencies trade in something called foreign exchange markets, or forex. Individuals typically don't trade in this market; big financial institutions, multinational corporations, and hedge funds would be more typical participants. Just like with stocks, the supply and demand for each currency fluctuates continuously. Is a country's facing inflation or other economic trouble? That could make its currency less valued. And that could in turn hurt the economy.
How do exchange rates factor into your investment decisions?
The investment that you own does its bookkeeping usually in the local currency. In the US, always in US dollars. In other countries, it can vary. So be sure you understand what currency they are using.
Reports are almost always issued with numbers in that currency. And for comparison purposes that is usually the best way to deal with things. It lets you know if the company is doing better compared to last year or last quarter or not, and numbers like dividends paid or long term debt can be converted to ratios or percentages and related directly to earnings.
Of course, you want to know what the investment pays in your currency, or what it costs or is worth. Those numbers change daily with currency exchange rates. That complicates things. If you take for example per share earnings for the last five years, you can convert each of those numbers based on today's exchange rates or on the exchange rate on the date reported, etc. So you get two values for each data point. Which one matters? Usually you want the constant dollar one for investment decisions, but if your investment is intended to benefit from changes in currency exchange rates, then you want to use the adjusted value.
Another aspect is how much of the company's earnings are made in foreign currencies which then get converted to home currency equivalents for reporting.
The bottom line is, exchange rates add another level of complexity which can benefit a savy investor, but much depends on what you plan to do with the information. So be aware and select accordingly.
Related Fool Articles
Recent Mentions on Fool.com
- 4 Banking Terms Every First-Time Homebuyer Should Know
- Don?t Take No For an Answer: Lessons From Organ Donation
- 3 Reasons Westport Innovations Inc. Stock Could Soar
- Oracle Corporation Is On the Wrong End of a $5.5 Billion Obamacare Fiasco
- Why Royal Gold, Inc Stock Has Skyrocketed 67% in 2014
- 5 Things Tiffany