Foreign Exchange

Foreign exchange adjustments for investments become necessary when organizations
invest in multiple currencies. The investment firm may consider several factors influencing
exchange rates such as inflation, public debt, political stability, and import-export trade balance
on the local scene. When charging for the foreign exchange cost, the investment firm must
consider some or all factors mentioned above. For example, due to high inflation, a low-interest
rate may force the investment firm to make most of its investments in another currency besides
the dollar, thus reducing the demand and the dollar value. An organization may be forced to
charge its customers an exchange rate fee for overseas investment. The exchange rate fees are
charged to cushion the investment firm against risks caused by exchange rate volatilities (Corte
et al., 2016). For example, assuming that the investment firm has invested in shares trading in the
London Stock Exchange, it may convert the US dollar to the Great Britain pound. Assume that
during the trade, the US dollar loses value over the Great Britain Pound. It means that the
investment firm gets less value for every transaction where the currency is exchanged with the
Great Britain Pound.
For this reason, the investment firm has to charge the customer an investment rate
adjustment cost to cushion against US dollar devaluation. If the US dollar depreciates against the
Great Britain pound, it means that the investment pays more for a unit of investment purchased
in the pound. Additionally, an exchange rate adjustment cushions investors against the adverse
effects of inflation. Assuming that the investment firm in Toronto purchases a large volume of its
investments in the Euro, it may need to adjust for foreign exchange risk to cushion the local
currency against further devaluation.

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The central banks set foreign exchange rates. In many countries, the central banks are the
sole implementors of monetary policy. There are two ways to do such determination: through
floating rates or fixed rates. A floating exchange rate is determined when open market activities
affect the demand and supply of foreign currency in an economy (Ippolito et al., 2018).
Assuming that the investment firm and others across the United States purchase a large volume
of investment units in the Euro, the demand for Euro increases, its supply reduces, and its value
increases. The actions of central banks affect the fixed-rate through their trading (buying and
selling) activities against the pegged currency. Therefore, the investment firm deals with the
exchange rate due to circumstances that it cannot fully control since most of the activities that
determine the exchange rates are determined by other investors who trade in a foreign currency
(Jeanerret 2015).
The investment firm exists to make a profit, and as such, it must transfer any extra costs
such as exchange rate costs to the customers. Over and above whatever the exchange rate is, after
factoring in the currency volatility, banks and investment firms add a profit margin. At the end of
the transaction, customers pay for two costs: the cost for the forex volatility and the investment
firm’s margin. The customers can avoid the foreign exchange costs by investing in local
currency. This way, the investment firm does not have to exchange currencies; therefore,
currency volatility risks and costs are eliminated.

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References

Corte, P., Ramadorai, T., & Sarno, L. (2013). Volatility Risk Premia and Exchange Rate
Predictability. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.2233367
Ippolito, F., Ozdagli, A. K., & Perez-Orive, A. (2018). The transmission of monetary policy
through bank lending: The floating rate channel. Journal of Monetary Economics, 95,
49–71. https://doi.org/10.1016/j.jmoneco.2018.02.001
Jeanneret, A. (2015). International Firm Investment under Exchange Rate Uncertainty*. Review
of Finance, 20(5), 2015–2048. https://doi.org/10.1093/rof/rfv054