How Exchange Rates Affect Agricultural Markets

Introduction

The exchange rate between two currencies specifies how much one currency is worth in terms of the other. The Canadian exchange rate impacts the competitiveness of the agriculture sector bythrough affecting producer prices of agriculture products and inputs and, therefore, producers’ profits. This module will provide an overview of what is the exchange rate is, what factors determine the exchange rate, the effects of changes in exchange rates on agricultural markets, and, briefly, how to manage the risk of currency exchange fluctuation.

What is the Exchange Rate?

The exchange rate is the rate at which you can trade one currency for another. The exchange rate of the Canadian dollar refers to the value of the Canadian dollar againstin terms of the currencies of other countries. There are two ways to express the exchange rate. One method is the number of units of the foreign currency necessary to purchase one unit of the domestic currency. For example, an exchange rate of 0.7760 means $0.7760 U.S. dollars arewould be needed to purchase one Canadian dollar. The other method expresses the number of units of the domestic currency necessary to purchase one unit of the foreign currency. For example, the $same0.7760 rate could also be expressed as requiring 1.2886 Canadian dollars to buy one U.S. dollar. In other words, $0.7760 is really 1/1.2886 and 1.2886 is really 1/0.7760.

The $0.7760US exchange rate is what we sometimesalwaysusually hear from the radio or TVin the media. ;I it is the value of the Canadian vs. the U.S. dollar from the Canadian’s perspective. To avoid confusion, this papermodule will use stick with the Canadian perspective this of expressing the Canadian dollar exchange rate,, which means one Canadian dollar is worth, for example, US$0.7760 dollars.

Changes of exchange rates are highly relarelevanttedimportant to farm businesses. Among all the foreign currencies significant to Canadian agriculture and food (agri-food) business, arguably the most important one is the U..S.. dollar. There are a number of rereasons. areisareA large percentage of Canadian agri-food exports go totake place with the U.S., mMostany of the farm commodities’y prices are determined in the U.S., aA considerable amount of Canadian farm inputs (e.g. machinery, fertilizer and pesticides) are imported from the U.S., And, finally, most of Canada’s agri-food trade taken place with other countries areis priced in U.S. dollars. Figure 1 shows the Canadian dollar exchange rate in terms of the U.S. dollar.

What factors influence the exchange rate?
In the short-term, the exchange rate is determined by the flow of a currency between two countries. Currency flow is affected by interest rates, trade balance and investors' confidence and expectations in one country relative to those issues in another country.

A rise in interest rates in Canada relative to other countries may result in a rise in the exchange rate of the Canadian dollar. When Canadian interest rates increase, foreign investors will choose to invest in Canada to take advantage of the higher interest rates by purchasing Canadian financial assets, provided that the inflation is low and stable relative to other countries. The conversions of foreign currencies into Canadian dollars to invest in Canada will increase the demand for Canadian dollars causing the Canadian exchange rate to increase. A decline in the interest rate may have the opposite effect. Canadian interest rates are generally determined by interest rates in the U.S., the relative inflation rates in both countries, and the relative stances of each country's monetary policies implemented by the two central banks- the Bank of Canada and the U.S. Federal Reserve.

The Canadian trade balance affects the value of the Canadian dollar, as well. When Canada earns more from sales of exports than it pays for imports, it has a trade surplus. A trade surplus increases the demand for the Canadian dollar and usually results in a rising Canadian dollar. On the other hand, a trade deficit will lower 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 are confident in the political and economic stability of Canada, they will be more likely to purchase Canadian assets, which may push up the value of the Canadian dollar.

Why are Exchange Rate Changes Important for Farm Business?

Changes inof exchange rates influence the agriculture sector in many ways. Exchange rate changes impact Canadian throughexport product prices, the price of imported inputs, farm margins, and, thustherefore, the competitiveness of the Canadian agriculture industry.

Changes in the exchange rate affect the competitiveness of Canadian exports in the international market. An increase in value of the loonie will influence the agriculture industry by making Canadianthe products more expensive for foreigners unless Canadian producers accept a lower price for their products. Both thus makeing producers them less competitive. A decrease in value of the Canadian dollar will generally increase exports and make producers more competitive, at least, in the short term.

Among all the exchange rates, the Canadian exchange rate versus the U.S. dollar is arguably the most important one, because a large amount of Canadian agri-food trade is taken place with the U.S. In 2003, the U.S. market representeds 59% of Alberta’s total agri-food export sales. For example, a producer If you are selling hogs hogs to the U.S. market, based on aand signed a contract based paid in on the U.S. dollars, you mayis be exposed to the exchange rate risk. Suppose the Canadian dollar increased in value from $0.70 US per Canadian dollar to $ 0.80. If the price of lean hogs in the UScontract is $78 U.S. per cwt, the price the Alberta farmer would receive at the US$0.70 exchange rate would be $111.43Cdn (US$78/0.7) Canadian per cwt. At the USexchange$0.80 rate, the farmer would receive $0. 97.5Cdn (US$78/0.8) Canadian per cwt. The price of the hogs in the U.S. has not changed, but the revenue that Alberta farmers receive fell as the Canadian dollar rose. Canadian hog Pproducers in that situation willould have to lower their prices or seeklook for ways to increasedecrease their marginscosts in order to maintain their market share.

Many Canadian agricultural exports, even those that are not destined for the United States, are priced in U.S. dollars. Suppose the Canadian dollar increases in value relative to the American dollar,. In that case, Canadian exports will appear more expensive to buyers, if the price in Canadian dollars remains constant. When these exports compete with U.S. products directly, the increase of the Canadian dollar against the U.S. dollar will result in competitive disadvantage of ourfor Canadian exports. Whether Canada will face a competitive advantage over other exporters, the European for instance European Union andor Australia, for instance, depends on the direction and the magnitudeamount of the movement of competitor’s currencies against the U.S. dollar.

The second reason that exchange rate changes are important for farm business is that the prices of many, but not all,of commodities are essentially determined by U.S. futures markets. Even though youan individual producer may not be an exporter directly, the prices of yourhis or her products can be affected by changes of the Canadian exchange rate versus the U.S. dollar. For example, the value of the Canadian Wheat Board “fixed price contract” begins with the Minneapolis futures prices for Hard Red Spring. Suppose the Minneapolis December ’04 wheat futures contract was valued at US$3.64 per bushel. When the exchange rate is US$0.70 per Canadian dollar, the pricevalue of the Dec 04 wheat futures is for the wheat is $191.23 Canadian per tonne. If the exchange rate increases to US$0.80 per Canadian dollar, the value of that wheat futures would be just that tonne of wheat will be $167.32Cdn per tonne. The world price of wheat has not changed, but the price the Canadian farmer willwould receive through the fixed price contract is significantly less due to the increase of the value of the Canadian dollar.

The third reason is that a considerable amount of farm inputs, such as machinery, fertilizer, pesticides and some animal feeds, are imported. An increase of the Canadian dollar will decrease the cost of imported inputs, but and a decrease of the loonie will increase the cost of imported inputs. Impacts on costs are significant since the amount of imported inputs is high. The value of imported farm inputs inputs in the primary agricultural sector is roughly 50% of the value of agricultural exports in the agriculture sector for Canada, and it is roughly 43% for Alberta. However, cost savings are different for different sub sectors. For example, in Alberta, cost savings from a rise in value of the Canadian dollar on imported inputs will be higher in the crops sector where costs of imported inputs are as high as 52% of the value of crop exports. It is important to remember, however, that price changes on imported inputs depend on the willingness or ability of supplying companies to pass the exchange rate changes on to producers.

In the long-term, exchange rate changes influence the investment and production in the agriculture sector. In the decade ending in 2001, a decreasing Canadian dollar is one of the reasons that Canadian and Alberta agri-food exports gained a steady competitive advantage. Recently, some of this competitive advantage willhas been eroded with the sharp increase of the looniein the value of the Canadian dollar vs. the U.S. dollar that began in early 2002. The agri-food industry has tomust improve productivity and efficiency in order to retainkeep competitiveness and maintain theirits market shares inof the international market if the Canadian dollar exchange rate continues to increase.

How to Manage the Exchange Rate Risk - a Quick Tool

Exchange rate risk may be managed through atwo ways - by hedginge transactions on the futures or options markets, or and through an exchange forward or options contract with a bank.

There are two possible situations where the futures market could be used to manage exchange rate risk. Let's supposeFirst, when a Canadian producer plans to needs to sell a product at a price, which is originally set in the U..S.. marketdollars. , tThe risk to the producer is that the cash price the producer receives, in Canadian dollars, will fall if the Canadian dollar rises. That exchange rate risk can be hedged managed by taking a long (buy) position on the Canadian dollar futures market. Any loss in the cash value of the product, due resulting to thefrom the rising Canadian dollar, will be offset by the gain on the long (buy) position of the Canadian dollar futures. The product seller reverses the futures hedge by selling back the long Canadian dollar position when the product is actually sold.

Let's suppose a Canadian processor or producer needs to buy a product, that is priced in the U.S. marketdollars. The risk to the Canadian processor is that he/she must pay a higher commodity price if the due to a falling Canadian dollar falls in value. In this case, the processor or producer can take a short (sell) Canadian dollar futures position., and reverse the hedge by buying back the short position when the cash sale is made. If the value of the Canadian dollar drops, the higher Canadian price in Canadian dollars paid paid by the producerbuyer forof the product, would be offset by a profit on the Canadian dollar futures position. The product buyer reverses the futures hedge by buying back the short position when the product purchase is made.

Foreign currency options can also be used to manage exchange rate risk. A foreign currency option allows a producer to exchange one currency for another on a given date, at a prearranged exchange rate (called the strike price), but the producer is not obligingobligated the producer to do so. Unlike the forward contracts discussed below, a producer isdo not obliged to the deal if the spot exchange rate is more favourable than the option 's strike exchange rate. The advantage of the foreign currency option is that it protects against an adverse movement in the exchange rate, while at the same time any favourable currency change is not given up by the holder of the option. There are two types of option contracts - a put (sell) option and a call (buy) option. A The risk that the Canadian dollar may rise can be hedged by buying call options. A The risk that the Canadian dollar may fall can be hedged by purchasing put options.

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

Other modules will address ways of managing exchange rate risk in more detail.

Summary

The exchange rate is the ratio at which one currency can be exchanged for another currency. It is determined by the flow of currencies, interest rates, trade balance, and investor confidence. Changes in the Canadian exchange rate have significant impacts on Canadian exports and investment and production in the agri-food industry. The exchange rate of the Canadian dollar against the U.S. dollar is arguably the most important to Canadian producers, since a large proportion of the agri-food trade is with the U.S. and the prices of many of the farm commodities traded are originally determined in the U.S.

An increase of the Canadian dollar will reduce the competitive advantage of the agriculture industry by making the exports more expensive for buyers. On the other hand, imported inputs become cheaper with an increase in value of the loonie. A slipping loonie will increase Canadian exports and decrease imported inputs. In the long run, changes in the exchange rate may influence the investment in and production of the agriculture sector.

Producers can manage their exchange rate risk through a hedging transaction in the futures or options market, or by using a forward exchange contract or option through their local bank. The risk that a commodity's Canadian price may fall due to an increase of the Canadian dollar can be managed by a hedge by purchasing Canadian dollar futures or call options. The risk that the imported input price may increase due to a decrease of the loonie can be hedged by selling Canadian dollar futures or buying put options.