When a firm operates only in the domestic market, both for procuring inputs as well as selling its output, it needs to deal only in the domestic currency. As companies try to increase their international presence, either by undertaking international trade or by establishing operations in foreign countries, they start dealing with people and firms in various nations. Since different countries have different domestic currencies, the question arises as to which currency the trade should be settled in. The settlement currency may either be the domestic currency of one of the parties to the trade, or may be an internationally accepted currency. In this case, Rolls-Royce has agreed on a dollar as the currency for settlement. The mechanism by which the exchange rate between these currencies i.e. the value of one currency in terms of another currency is determined, along with the level and the variability of the exchange rates, can have profound effect on the sales, cost and profits of a firm. The change in the value of currencies takes place because of the change in the demand for holding that particular currency. The businesses may be affected in a number of ways because of the changing exchange rate. Some of them are as follows:
Exchange rates may be of different types like fixed exchange rate, floating exchange rate and also exchange rates with limited flexibility. Different kinds of exchange rate systems have different methods of correcting the disequilibrium between international payments and receipts. This actually is one of the basic functions of these mechanisms.
Fixed Exchange Rate System - As the name suggests, under a fixed or pegged exchange rate system the value of a currency in terms of another is fixed. These rates are determined by governments or the central banks of the respective countries. The fixed exchange rates result from countries pegging their currencies to either some common commodity or to some particular currency. There is generally some provision for correction of these fixed rates in case of a fundamental disequilibrium. The Gold Standard System and the Breton Woods System are some of the examples of Fixed Exchange Rate System. There are also particular variations of the fixed rate system like:
Currency Board System - Under this system, a country fixes the rate of its domestic currency in terms of a foreign currency, and its exchange rate in terms of other currencies depends on the exchange rates between the other currencies and the currency to which the domestic currency is pegged. The biggest advantage of a currency board system is that it offers stable exchange rates, which act as an incentive for international trade and investment. The discipline enforced on the government and the financial system also helps in improving the macroeconomic fundamentals in the long run.
Target Zone Arrangement - A target zone arrangement is system in which a group of countries sometimes get together, and agree to maintain the exchange rat