Foreign Exchange Risk, Appreciation and Depreciation


Foreign Exchange Risk

At first glance it may seem irrelevant which way an exchange rate is expressed. However, it is important because the words appreciation and depreciation of a currency are used in the market. This may be confusing if the wrong method is used. An illustration may explain the afore said statement

Suppose that the United States Dollar (USD)/Local Country Currency (LCC) exchange rate changed from USD LCC 10.23 to USD LCC 10.56. It may seem to some that LCC has appreciated. It has actually depreciated. In the first case, LCC 10.23 was required to purchase USD 1, whereas in the second case, LCC 1056 was required. This means that the USD has appreciated and the LCC has depreciated.

When these two exchange rates are reversed, they turn into LCC/USD 0.09775 and LCC/USD 0.09470. The same finish is arrived at less USD are obtain per LCC in the second case compared with the first. The LCC has depreciated against the USD, and the USD has appreciated against the LCC.

It is to be noted that the LCC depreciation and the USD appreciation are not the same in percentage terms. If for example the USD/LCC exchange rate shifts from USD/LCC 10.23 to USD/LCC 13.80, it has altered by plus LCC 3.57 per USD. The home country buyer of USD has to pay LCC 3.57 more per USD. Thus, the USD has appreciated by 34.897% over the period.

It is important to highlight tow issues. The first is that the terms appreciation and deprecation must be used with care. In the above example, where the USD appreciated by 34.897%, some would say that e converse also applies. Like that the LCC depreciated by 34.897%. This is not the real case. The LCC depreciated by a different percentage. The rule that applies here is that the currency that appreciates or depreciates is the one with the one unit i.e. the base currency and not the variable currency. In the above case the currency with one unit in terms of which the number of LCC is expressed is the USD.

The second point is over the period is mentioned because the USD appreciated between the day the LCC was quoted as USD/LCC 10.23 and they day the LCC was quoted as USD/LLC 13.80. Therefore it is not an annual rate; it is change over a period.

The computation of the depreciation or depreciation in percentage is illustrated below

[{(ER1 –ER0)/ER0} x 100] Where

ER0 = Exchange rate at the original time                 = USD/LCC 10.23

ER1 = Exchange rate at the new time                       = USD/LCC 13.80

In the above example

Percentage change in exchange rate      = [{(Exchange Rate1 –Exchange Rate0)/ Exchange Rate0} x 100]

                                                                                = [{(13.80 –10.23)/10.23} x 100]

                                                                                = {(3.57/10.23) x 100}

                                                                                = 34.897%

As noted, this is the percentage change in the USD, and this because the USD is the base currency. The extent to which the LCC depreciated is calculated by inverting the above two exchange rates. The number of USD in terms of one LCC and the LCC becomes the base currency. The following are the relevant numbers

                                                ER0         = 1/10.23                             = LCC/USE 1.09775

                                                ER1         = 1/13.80                             = LCC/USD 0.07246

Percentage change in exchange rate      = [{(Exchange Rate1 –Exchange Rate0)/ Exchange Rate0} x 100]

                                                                                = [{(0.07246 –0.09775)/0.079775} x 100]

                                                                                = {(- 0.02529/0.079755) x 100}

                                                                                = – 25.872 %

In this case the LCC depreciated by 25.872% but the USD did not appreciated by 25.872%. It certainly appreciated but it did so by 34.897% as shown above.