How Exchange Rates

7/28/2019 How Exchange Rates

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How Exchange Rates Affect Agricultural Markets

Introduction

The exchange rate between two currencies specifies how much one currency is worth in terms of theother. The Canadian exchange rate impacts the competitiveness of the agriculture sector by affectingproducer prices of agriculture products and inputs and, therefore, producers’ profits. This module providesan overview of what is an exchange rate, what factors determine the exchange rate, the effects of changes in exchange rates on agricultural markets, and how to manage the risk of currency exchangefluctuation.

What is the Exchange Rate?

The exchange rate is the rate in which one currency of one country is valued relative to the currency of another country. There are two ways to express exchange rates:

The number of units of foreign currency necessary to purchase one unit of domestic currency.For example, an exchange rate of 0.978 means $0.978 US dollars would be needed to purchaseone Canadian dollar. This is usually how the US rate is reported in the mediaThe number of units of domestic currency necessary to purchase one unit of foreign currency. Forexample, the $0.978 rate could also be expressed as requiring 1.022 Canadian dollars to buy oneUS dollar. In other words, $0.978 is really 1/1.022 and 1.022 is really 1/0.978.

Changes in exchange rates are highly relevant to farm businesses. As most farm commodity prices aredetermined in the US, the most significant foreign currency to Canadian agriculture and food (agri-food)business is the US dollar. This is due to a large percentage of Canadian agri-food exports being sold tothe US, a considerable amount of Canadian farm inputs (e.g. machinery, fertilizer and pesticides) areimported from the US and most of Canada’s agri-food trade that takes place with other countries arepriced in U.S. dollars. Figure 1 shows the Canadian dollar exchange rate in terms of the U.S. dollar.

Figure 1.

What factors influence the exchange rate?

In the short-term, the exchange rate is determined by the flow of a currency between two countries.

$0.60$0.65

$0.70

$0.75

$0.80

$0.85

$0.90

$0.95

$1.00

$1.05

$1.10

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C a n a d i a n D o l l a r V a l u e

Monthly Average Canadian Dollar vs US Dollar Exchange Rate

Source: Bank of Canada



Currency flow is affected by interest rates, trade balance, investors' confidence and issues and/orexpectations in one country relative another country.

The Canadian trade balance affects the value of the Canadian dollar. When Canada earns more fromsales of exports than it pays for imports, it has a trade surplus. A trade surplus increases the demand forthe Canadian dollar and usually results in a rising Canadian dollar. On the other hand, a trade deficit willlower the demand for Canadian dollars and cause a decrease of the Canadian dollar exchange rate.

Foreign investors' confidence and expectations will also influence the exchange rate. If investors areconfident in the political and economic stability of Canada, they are more likely to purchase Canadianassets, which may push up the value of the Canadian dollar.

Why Exchange Rate Changes are Important to Farm Business?

Changes in exchange rates influence the agriculture sector. Exchange rate changes impact Canadianexport prices, the price of imported inputs, and the competitiveness of the Canadian agriculture industry.

The Canadian exchange rate versus the US dollar is arguably the most important as 32% of Alberta’stotal agri-food export sales were to the US.

Changes in the exchange rate affect the competitiveness of Canadian exports in the international market.An increase in the loonie will influence the agriculture industry by making Canadian products moreexpensive for foreigners, unless Canadian producers accept a lower price for their product. A decrease inthe Canadian dollar will generally increase exports and make producers more competitive. The exchangerate will also affect commodities that are priced in the US futures market.

As an example a Canadian hog producer signs a contract to sell hogs in the US in US dollars. TheCanadian dollar increased in value from $0.95 US per CDN to $ 1.05 If the price of lean hogs on the UScontract is $135 US per cwt, the price the Alberta farmer would receive at the $0.95 exchange rate wouldbe $142.10 Cdn per cwt (US$135/0.95). At the $1.05 rate, the farmer would receive $128.57 Cdn per cwt(US$135/1.05). The price of the hogs in the US had not changed, but the revenue the Alberta farmerreceived fell as the Canadian dollar rose. Canadian hog producers in this situation would have to lowertheir price, look for ways to increase margins or decrease costs to remain competitive.

Even if agricultural products are not destined for the US many of these products are priced in US dollars.If exchange rates rise, Canadian exports will appear more expensive to buyers if the price of the productprice remains constant in Canadian dollars. When these exports compete with US products directly theincrease in Canadian exchange rates will result in a competitive disadvantage for Canadian exports.When Canada competes against other exporters (European Union and Australia) the competitiondepends on the direction and magnitude of the competitor’s currencies against the US dollar.

As a large amount of farm inputs (machinery, fertilizer, pesticides) are imported exchange rates will affectcosts. An increase in the Canadian dollar will decrease the cost of imported products and a decrease inthe Canadian dollar will increase the cost of imported inputs. However the price changes on importedinputs depends on the willingness or ability of the suppliers to pass the exchange rate changes toproducers.

In the long-term, exchange rate changes influence the investment and production in the agriculturesector. The agri-food industry needs to improve productivity and efficiency in order to remain competitivein the international market if the Canadian dollar remains high.

How to Manage the Exchange Rate Risk - a Quick Tool

Exchange rate risk may be managed two ways - by hedging transactions on the futures or optionsmarkets, or through an exchange forward or options contract with a bank.



When a Canadian producer plans to sell a product at a price which is originally set in the US market, therisk is the cash price the producer receives in Canadian dollars, will fall if the Canadian dollar rises. Theexchange rate risk can be hedged by taking a long (buy) position on the Canadian dollar futures market.Any loss in the cash value of the product, resulting from the rising Canadian dollar, will be offset by thegain on the long (buy) position of the Canadian dollar futures. The product seller reverses the futureshedge by selling back the long Canadian dollar position when the product is actually sold.

Alternately if a processor or producer needs to buy a product in the US market the risk would be that theymust pay a higher commodity price if the Canadian dollar falls. In this case the processor or producerswould take a short (sell) Canadian dollar futures position and reverse the hedge by buying back the shortposition when the cash sale is made. If the value of the Canadian dollar drops, the higher price inCanadian dollars paid by the producer for the product would be offset by a profit on the Canadian dollarfutures position. The product buyer reverses the futures hedge by buying back the short position whenthe product purchase is made.

An exchange forward contract allows the producer/processor to buy or sell one currency against anotherfor settlement on the day the contract expires. A forward contract eliminates the risk of fluctuation of theexchange rate by locking in a price today for a transaction that will take place in the future. The produceror processor can arrange a forward contract or option with their local bank. However, theproducer/processor needs to be aware that there are specific requirements on credit (or farm credit), andthe cost associated with these transactions. Anyone considering using an exchange forward shouldspeak with their local bank representatives first.

Summary

The exchange rate is important to follow if selling or buying commodities internationally. Fluctuations inexchange rates can increase risk and volatility for product prices. By using tools such as hedging andforward contracts the risk can be reduced.

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How Exchange Rates