A currency exchange rate denotes the value of one currency with respect to another. Most exchange rate quotations are with respect to the U.S. dollar. Under a fixed exchange rate system, such as in China, the government determines the devaluation and revaluation of its currency. In a floating exchange rate system, such as in the United States, market forces determine currency depreciation or appreciation. Devaluation or depreciation means a decline in the value of the currency, which affects bonds, stocks, mutual funds and other investments.
The Federal Reserve's Joseph E. Gagnon said that exchange rate depreciation could push up domestic inflation through higher import prices. Investors would require higher returns to compensate for the inflation and would expect the Fed to raise interest rates to fight off inflation, which would push up interest rates even more. Given the inverse relationship between bond prices and interest rates, a currency crash, which is a rapid fall in the currency, could also lead to a bond market crash.
A strong dollar can actually hurt the bottom line of U.S. companies when translating foreign income, according to currency consultant Bryan Rich. Conversely, a depreciating or weak dollar increases the exchange rate for foreign-currency denominated sales and profits. A low dollar could actually help exporters, such as manufacturing companies, because U.S. products would become more price competitive in overseas markets. This could increase profits and potentially stock prices. However, as Gagnon suggests, import prices would also rise, leading to inflation. In an article on the Elon University website, author Desislava Dimitrova cites peer-reviewed research to state that currency depreciation leads to stock price declines in the short run precisely because of possible inflation, which is usually a negative for corporate profits and stock prices.
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The Royal Bank of Canada Global Asset Management website describes the impact of foreign exchange depreciation and devaluation on Canadian mutual funds holding U.S. and other foreign stocks. However, the concept applies equally to U.S. mutual funds holding European stocks or European mutual funds holding Japanese stocks. For example, if the Canadian dollar or the euro were to fall, the value of Canadian and European investments held by U.S. mutual funds would decline. However, the currency-related impact is minimal over the long term.
Hedging protects revenues and profits from currency fluctuations. Rich suggests that most companies underestimate the impact of currencies and the importance of having a hedging program in place. Small businesses often do not have the expertise to implement a hedging program, and some do not believe that hedging is worth the effort. Rich states that about a quarter of the large companies with foreign currency exposure do not have any hedging program at all.