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An Introduction to Exchange Rates

Finally, your vacation time is coming up and you can’t wait to look for the next exotic destination to explore. But if you were to travel overseas, you most likely wouldn’t be allowed to use the US dollar to purchase goods from a store. You would have to find a bank and exchange your money. You would have the same amount of money, just in a different currency. But when the rate varies up or down, you will either get more or less of the foreign currency.

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Exchange Rate Examples

Let’s use an important real world scenario that plays out each week right here in the US. Dave and Buster’s, for those of you who don’t have one nearby, is an entertainment establishment that has a restaurant, bar, lots of big screen TV’s, and pool tables. But what you go to Dave and Buster’s for is the games. Now, to play those games you need tokens. So we “exchange” our dollars for tokens which are the currency of choice at Dave and Buster’s. Roughly speaking $20 equals 100 tokens. The idea would be to hold on to those tokens until the rate changes to say $30. You would then sell your 100 tokens for $30 and pocket a $10 profit. But wait, it gets more interesting. Each Wednesday is half price Wednesday. Now our $20 buys 200 tokens! Now I’m thinking that the rate will probably go back up on Thursday so I will hold on to my 200 tokens. Sure enough, when Thursday rolls around, $20 only buys 100 tokens again. Well, now I sell my 200 tokens for a whopping $40! I doubled my profit by finding the lowest rate and selling at a higher rate. Simple. Unfortunately, though, there aren’t many instances where you can predict a 50% decrease in the exchange rate except at Dave and Buster’s.

Now here’s another real world scenario that will affect a person’s thinking about purchasing stock in a company. Let’s say Company Z has a great new product but their only real market is in Japan. So Company Z decides to build a base plant in Japan to reduce shipping costs in the long run. To build that plant, pay workers, buy materials, etc., they need to buy the Japanese Yen by selling US dollars. If the exchange rate is low, then it’s a bargain to build the finest plant in Japan. But if the rate is high, perhaps it is an added expense they will have a hard time paying for. What happens if they have a hard time paying for it? They might sell off some of their stock. What happens to the stock price after a sell off? Yep, you just learned how currency exchange can cost you some money in the stock market.

Now how can currency exchange make us money in the stock market? We could start by investing in developing markets that have a strong export economy. Let’s say that Company X is in India and they make Justin Bieber dolls. Let’s say the Indian Rupee is weak against the dollar so for the US it is cheap to buy Bieber dolls from India. If you are a stock holder in Company X, you are making a fortune. Your company is getting paid in US dollars which Company X can now sell back and make an additional income on the difference in exchange rate. Cha-ching! Additional income on the bottom line. Stock price goes up. India becomes a global economic power. And because you invested in Company X because you are a Bieber believer, you made a tidy profit as well.

Exchange Rate Variables

There are a lot of variables in the exchange rate. The Forex market is open 24 hours a day 5 days a week. Trillions of dollars are exchanged daily. The market is so big that it usually doesn’t fluctuate to a great extent and is generally considered pretty safe. But not always. Think 9/11. Think Japanese earthquake. These are unforeseen circumstances that can happen in the blink of an eye that sends the world markets in chaos. You can be asleep dreaming of hitting the winning World Series home run only to wake up with no more money in your Forex account. There is no sure bet in trading.

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The moral to this story is that the currency rate is usually only looked at by people who buy and sell currency. Exchange rates can be tricky as we have seen here today. They can have a big impact on your stock portfolio as well. The next stock you investigate, dig a little deeper and see what kind of dealings they have with foreign markets. It just might get you a few extra tokens.

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