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 by affecting prices of agriculture products and inputs and, therefore, farms' profits.

In this section you will learn:

• more what an exchange rate is
• what factors determine the exchange rate
• the effects of changes in exchange rates on agricultural markets
• how to manage the risk of currency exchange fluctuation

Although the major market for currency in the world is Forex, other markets like Chicago Mercantile Exchange (CME) or Chicago Board Options Exchange (CBOE) offer currency exchange rate products.

The currency abbreviation or currency symbol for the Canadian dollar is CAD or C$, and the United States dollar is USD or US$.

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 2 ways to express exchange rates:

1. The number of units of foreign currency necessary to purchase one unit of domestic currency. For example, an exchange rate of 0.9312 means US$0.9312 would be needed to purchase one CAD.
2. The number of units of domestic currency necessary to purchase one unit of foreign currency. For example, the 0.9312 rate could also be expressed as requiring C$1.0739 to buy one USD. In other words, $0.9312 is really 1 divided by 1.0739, and 1.0739 is really 1 divided by 0.9312.
3. Changes in exchange rates are relevant to farm businesses. The most significant foreign currency to the Canadian agriculture and food business is the USD. This is due to the high level of trade between Canada and the United States. A large percentage of Canadian agri-food exports are sold to the United States and a considerable amount of Canadian farm inputs, such as machinery and pesticides are imported from the United States. In addition, most of Canada's agri-food trade that takes place with other countries is priced in USD. The USD is the dominant world currency.

Image 1. Chart showing Canadian versus United States dollar exchange rates from 2015 to 2020. (Source: Bank of Canada.)

Influencing factors on exchange

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, investors' confidence and issues or expectations in one country relative to another country.

The Canadian trade balance affects the value of the CAD. 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 CAD and usually results in a rising CAD. On the other hand, a trade deficit will lower the demand for CAD and cause a decrease of the CAD 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 are more likely to purchase Canadian assets. This may push up the value of the CAD.

Exchange rate and farm business

Exchange rate changes impact Canadian export prices, the price of imported inputs, and the competitiveness of the Canadian agriculture industry. The Canadian exchange rate versus the USD is arguably the most important as nearly 40% of Alberta's total agri-food export sales were to the United States in recent years.

Changes in the exchange rate affect the competitiveness of Canadian exports in the international market. An increase in the CAD will influence the agriculture industry by making Canadian products more expensive for importers, unless Canadian producers accept a lower price for their product. A decrease in the CAD will make producers more competitive and generally would increase exports. The exchange rate will also affect Canadian commodities that are priced in the United States futures market.

As an example, a Canadian hog producer signs a contract to sell hogs in the United States in USD. The CAD increased in value from US$0.95 per C$ to US$1.05 per C$. If the price of lean hogs on the United States contract is US$135 per hundredweight (cwt), the price the Alberta farmer would receive at the US$0.95 exchange rate would be C$142.10 per cwt (which is US$135 divided by 0.95). At the US$1.05 rate, the farmer would receive C$128.57 per cwt (which is US$135 divided by 1.05). The price of the hogs in the United States had not changed, but the revenue that the Alberta farmer received fell as the CAD rose.

In this situation, Canadian hog producers would have to lower their price, look for ways to increase margins or decrease costs to remain competitive.

Even if agricultural products are not destined for the United States, many of these products are priced in USD. If the CAD exchange rate rises and the price of the product remains constant in CAD, Canadian exports will appear more expensive to buyers.

When these exports compete with United States products directly, the increase in Canadian exchange rates will result in a competitive disadvantage for Canadian exports. When Canada competes against other exporters, such as European Union and Australia, the competition depends on the direction and magnitude of the competitor's currencies against the USD compared to ours.

As a large amount of farm inputs, such as machinery and pesticides are imported, exchange rates will affect those costs. An increase in the CAD will decrease the cost of imported products and a decrease in the CAD will increase the cost of imported inputs. However, the price change on imported inputs depends on the willingness or ability of the suppliers to pass on the exchange rate changes to producers.

In the long-term, exchange rate changes influence the investment and production of the agriculture sector. The agri-food industry needs to improve productivity and efficiency in order to remain competitive in the international market if the CAD remains high.

Manage the exchange rate risk

Exchange rate risk may be managed in 2 ways:

1. by hedging transactions on the futures or options markets
2. through an exchange forward or options contract with a bank

When a Canadian producer plans to sell a product at a price that is originally set in the United States market, the risk is that the cash price the producer receives in CAD will fall if the CAD rises. The exchange rate risk can be hedged by taking a long (buy) position on the CAD futures market. Loss in the cash value of the product resulting from the rising CAD will be offset by the gain on the long position of the CAD futures. The product seller reverses the futures hedge by selling back the long CAD position when the product is actually sold.

Alternately, if a processor or producer needs to buy a product in the United States, the risk would be that they must pay a higher commodity price if the CAD falls. In this case, the processor or producer would take a short (sell) hedge CAD futures position. If the value of the CAD drops, the higher price in CAD paid for the product would be offset by a profit on the CAD futures position. When the product purchase is made, the product buyer reverses the futures hedge by buying back the short position.

An exchange forward contract allows the producer or processor to buy or sell one currency against another for settlement on the day that 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 a bank. However, the producer or processor needs to be aware of bank specific credit requirements as well as costs associated with these transactions. Local bank representatives are the first contact for anyone considering an exchange forward contract.

Summary

Understanding exchange rate and its basic application is important for agricultural producers. Exchange rates impact agricultural commodity prices and farmers' margins. Most international agricultural transactions are in USD.

Agricultural businesses need to recognize the impact of fluctuating currency on their business and consider ways of managing this risk.

Exchange rate risk may be managed by producers in 2 ways:

• hedge transactions on the futures or options markets
• hedge through an exchange forward or options contract with a bank