Currency conversion continually monitors changes in exchange rates to determine the monetary value of a specific country’s currency in relation to another currency. An exchange rate is a rate at which one currency will be exchanged for another. It shows a country’s currency value compared to another. Individual countries determine the exchange rate regime to use on its currency. A country can adopt a pegged, free-floating or hybrid regimes. In a free-floating regime, an exchange rate is determined by the market forces of supply and demand and the currency is allowed to vary against other currencies. In pegged regime, exchange rates are fixed but can have a provision to allow for currency revaluation (Juselius and Assenmacher 1146). This paper analyzes Switzerland which uses the Swiss Franc as its currency to enhance understanding of the dynamics of currency conversion.
Switzerland produces sophisticated and high-quality products such as chocolates and watches, runs budget surpluses, maintains low inflation, possesses a strong currency which exchanges at 0.96 Swiss France for 1 U.S dollar and excels at wealth management. In 2013, the country ranked first in terms of average wealth per capita according to Credit Suisse Global Wealth Report. European Union ranks Switzerland as the most innovative country in Europe. These factors make the country attractive to investors in times of turmoil and lead to safe-haven capital inflows. For instance, during the Eurozone Crisis and Global Crisis, capital inflows intensified. Traditionally, the Swiss franc is a mechanism of preserving value than for active trading because the country is export-oriented; it is exposed to significant currency risks (Auer, Burstein, and Lein 124). As such, Swiss treasurers use the entire range of products to hedge the various forex risks, making the country to some of the most sophisticated currency risk managers.
Supply and Demand of Currency
The core purposes of a company wanting to convert currencies are pay or receive money for goods or services offered in a foreign country. For instance, a company is the U.S imports watches from Switzerland. The company will need to pay for those watches in the Swiss franc but it cannot access those currencies physically. The bank will convert the company’s US dollars into Swiss franc at the prevailing exchange rate. The exchange rate is dependent certain factors such as inflation rates, the balance of payments, terms of trade, recession, political stability and performance among other factors which consequently determine the supply or demand of a particular currency (Juselius and Assenmacher 1146). When the supply is higher and demand is low, the exchange rate reduces making it cheaper for a company to pay for goods and the vice-versa is true.
To protect companies in a country against the risk of exchange rates increasing or decreasing in greater proportions or directions than anticipated, a country adopts hedging strategies. Currency hedging is a practice of preventing potential losses that may occur due to unfavorable changes in exchange rates. Countries adopt hedging in order to protect its companies in times of time lag between when they bill and receive payment from customers. Frequently-used hedging instrument in Switzerland is known as the basket option to hedge multiple currency cash flows (Auer, Burstein, and Lein 127). The basket option provides the right to exchange two or more currencies for a base currency at expiration. For instance, an entity expects to receive income from exports to various countries. A put on the basket option consisting of these currencies gives the company the right to exchange the currencies for Swiss franc at expiration. The option is cash settled and the main advantage is its low cost, 15% to 20% cheaper.
Comparative Advantage
A country’s comparative advantage emanates from its capacity to produce a specific product more efficiently, which is using minimal resources than another country. This advantage is determined by the opportunity cost foregone in the production of a particular product. Opportunity cost measures the trade-off between countries. Good or service with a low opportunity cost is cheap for other trading partners to import (Juselius and Assenmacher 1148). Many countries in an effort to have a comparative advantage in today’s hyper-competitive global economy, they seek ways to lower production costs. These countries are mainly aided by the availability of huge human capital. However, a tiny country such as Switzerland with relatively a small population of less than eight million is banking on the industries of specialization and opportunity for its comparative advantage. The country’s competitiveness is embedded in producing high-quality and sophisticated products it specializes in as opposed to the field of low-cost goods and services.
Switzerland is well known for the manufacturing of high-quality brands of chocolate such as Lindt and Toblerone brands. In the production of chocolate, the country has a comparative advantage over the United States. It gives up producing one pound of corn so as to produce two pounds of chocolate in one hour rather than giving up two pounds of chocolate to produce one pound of corn in an hour. This implies that Switzerland will export more chocolate than corn, therefore racking in more foreign currencies which strengthens its franc. The good that a country produces most efficiently is the good in which comparative advantage is held. By producing a good or service with the lowest opportunity cost, a country makes the most efficient use of its resources handing it the comparative advantage (Juselius and Assenmacher 1150).
Conversion Process
Irrespective of how a country is endowed with varying resources, no country has the capacity to produce all commodities and services required in its economy. As such, all countries have to trade with one another to import what it does not produce and export excess of its produces. Each country has its unique form of currency, meaning importing country has a different currency to that of exporting country. Consequently, when two such countries are trading, importing country has to convert its currency to that of the exporting country. In absence of certain pre-arranged options such as hedging strategies, the currency is converted at the prevailing exchange rate (Jozef, Kočenda, and Vácha 40).
For instance, a United States’ company that imports chocolate from Switzerland or wines from around the world, it will have to pay the Swiss producers in the Swiss franc, the Chilean vineyards in pesos, the Australian wine suppliers in Australian dollars and the French winemakers in the euros. The company through its bank will convert the U.S dollars into the respective currencies of trading partners. To the Switzerland chocolate producers, the company will convert the US dollars according to the prevailing exchange of 1 US dollars equals to 0.96 Swiss francs.
Denominations Comparison
Since the 18th
century, the United States currency had been denominated to large notes of up to $100,000 notes. They mainly used for large transactions until 1933 when President Franklin Roosevelt confiscated large denominations such as $100,000 and limited their usage for only intra-governmental transactions. The printing and circulation of large denominations exceeding $100 were discontinued in 1969 by the United States Treasury. There are seven currency denominations issued since 1969: $1, $2, $5, $10, $20, $50 and $100. Despite the increment in inflation since 1969, it is unlikely that large denominations will be issued again due to concerns of the use of cash in unlawful activities such as money laundering and illegal drug trade and counterfeiting (Juselius and Assenmacher 1151).
In comparison, the Swiss franc has six denominations ranging from 10, 20, 50, 100, 200 and 1,000 Swiss francs. The francs are issued in series and the newer series are exchanged for older recalled series at the National Bank. After the recall, the older series becomes no longer a legal tender. Despite the inflation, the U.S government does not intend to print large denominations than $100 so long as the currency system meets its goal which is meant to serve the needs of the public (Juselius and Assenmacher 1153). Even though the Swiss franc is more secure than the U.S dollar, the dollar is more secure than other currencies such as Sterling Pound which has a counterfeit ratio of 1 in 3,333 sterling pounds as opposed to that of US dollar ratio of 1 in 10,000 dollars.
Payroll
Paycheck processing duties differ by type and the size of the company. However, some rules apply such as paying employees based on their salary or hours worked, withholding appropriate taxes and applicable voluntary deductions (Greenwood-Nimmo, Viet Hoang, and Rafferty 53). AT"T cleaning company is a start-up boasting of two employees who are paid weekly. The following is an excerpt of their payroll;
AT"T Company Payroll
Employee ID
Name
Hourly wage ($)
Hours worked
State tax %
Social security tax %
Medicare tax %
Total taxes withheld %
Gross pay ($)
Total taxes ($)
Net pay ($)
001
Tony Smith
6.9
40
2.3%
1.7%
1.13%
5.13%
$276
$14.1588 = $14.16
$261.84
002
Sharon Lee
6.9
40
2.3%
1.7%
1.13%
5.13%
$276
$14.1588 = $14.16
$261.84
The total taxes figure of $14.1588 is not the same as the rounded figure of $14.16 and consequently, the net pay due to employees is less by $0.0012. As such, according to the company’s policy is the amount of $0.0012 is added to the company’s charity fund which at the end of the year party is donated to the needy orphans. There is a consensus between the employees and the company about committing the $0.0012 difference to the charity fund.
Conclusion
As discussed, it is not possible for any country’s forex market to operate independent of global markets, because at one point a country will need what it does not produce. Even if an entity anticipates to be paid in its own currency, it must assess the risk that the buyer may not be able to pay the full amount due to the currency fluctuations. The challenge for companies is to operate in a world system that is not efficient. Currency markets are influenced not only by market factors, inflation, interest rates, and market psychology but also by government policies and intervention (Juselius and Assenmacher 1155). Hence, it is paramount for companies to actively monitor the markets in which they operate around the world.
Works Cited
Baruník, Jozef, Evžen Kočenda, and Lukáš Vácha. "Asymmetric volatility connectedness on the forex market." Journal of International Money and Finance 77 (2017): 39-56.
Greenwood-Nimmo, Matthew, Viet Hoang Nguyen, and Barry Rafferty. "Risk and return spillovers among the G10 currencies." Journal of Financial Markets 31 (2016): 43-62.
Juselius, Katarina, and Katrin Assenmacher. "Real exchange rate persistence and the excess return puzzle: The case of Switzerland versus the US." Journal of Applied Econometrics 32.6 (2017): 1145-1155.
Auer, Raphael, Ariel Burstein, and Sarah M. Lein. "Exchange Rates and Prices: Evidence from the 2015 Swiss Franc Appreciation." (2018): 122-136
