Let’s say I buy an online service priced in USD, but I’m paying from another country in my local currency.
Suppose I pay for the service when $1 = 84 units of my currency, and later get a refund when $1 = 82 units. Because my currency strengthened, I’d get back more local currency than I originally paid.
My questions are:
If I “gain” money because of this currency movement, who actually “loses” that money?
Is it the merchant, the bank, or someone else?
Or is it like in the stock market where gains and losses cancel out between people?
Is this gain real wealth created out of nowhere, or just my share of a bigger economic change?
Just trying to understand the economic intuition behind how forex gains on refunds work. Thanks for any insights!
Comments
You are buying something worth one dollar with local currency. Let’s assume when you pay for it a bank does the conversion for you.
So you pay 84 units of currency (doubloons?) to the bank, the bank pays $1 to the online merchant and you get the service.
Then you get a refund and the exchange rate is now 82 doubloons to the dollar, so the merchant gives $1 back to the bank, and the bank gives you back 82 doubloons. You’re down two doubloons and the bank is up two in this trade. Had the exchange rate changed in your favour you’d have gained at the banks expense. The merchant is operating in dollars all the time and sees no gain or loss.
I’m assuming the same bank handles conversion in both cases for simplicity here.
I’m also ignoring any fees the bank might charge for conversion. In reality the bank likely always makes a profit unless there is a significant exchange rate swing.
If your currency strengthens you actually get less of your currency back. In your example, if the cost was 1 USD you paid 84 of your currency but only receive 82 back. Regardless of whether you are making profit or losing money, whatever gain/loss you have is cancelled out by a loss/gain for whoever you bought the USD from. If they sold you the dollar for 84 units of your currency, they can now buy it back for 82 and keep 2 units as profit.
The 84 exchange rate is temporary and no exchange actually happens at that time, and the bank reserves a bit extra money over the expected exchange rate. Your bank later does the exchange (in bulk, or when the exchange is open) and they get an exact rate, you pay that rate then, and get refunded the extra you pay. So it doesn’t come from anywhere, your bank just holds the extra until it can get a fixed rate and then refunds the extra to you.
The reason that the exchange rate fluctuates between currencies is partly due to a difference in inflation rate.
Say country A had no inflation between the purchase and the refund, but country B had 4% inflation. If you’re in country B and use B50 to buy something from country A for $1, after inflation (in country B) you will get a refund of $1 (no change in value for the supplier), but will convert it back to B52.
The value you paid and received was $1 both times, but the number in B-currency was different. It looks like you gained money, but your purchasing power was unchanged.
In your example the supplier’s currency experienced more inflation than yours. The supplier refunded you $1, but that $1 was worth less to them than when you bought the thing.
This is actually a fairly subtle question, with no very concrete answers.
It may well be that nobody really “gained” or “lost” anything in this series of transactions, not even you, even though it feels like you did.
Note that you’ve got the numbers the wrong way around in your post – you get more of your currency if your currency weakens, and less if it strengthens. Let’s put numbers on a new example.
Let’s say that you purchase a foreign trinket for $1 when the exchange rate is $1 for 100 zorkmids, and then, for whatever reason, you get a refund when the rate is $1 for 105 zorkmids. You used to have 100Z, and now you have 105Z. That means you’re richer, right?
Well, yes and no. If the price of a hamburger in your country is 5Z, and it stays at 5Z over this entire time, then you can now afford 21 hamburgers instead of 20. Your local purchasing power has improved. But you can still only trade your zorkmids for $1, same as before, so your global purchasing power – your ability to buy foreign trinkets – has stayed the same. Which do you care more about, your ability to buy local hamburgers or your ability to buy foreign trinkets?
And that’s the crux of the problem when trying to figure out whether the wealth of the world increased, decreased or stayed the same through this process. “Wealth” can really only be defined by how much everybody needs, wants, enjoys or benefits from the things they have. I can only figure out whether you’ve become more “wealthy” by asking how much of your money you want to spend on 5Z hamburgers or $1 trinkets – if you want the hamburgers, you’ve gained wealth, but if you want the trinkets, you haven’t. Repeat that process for everything every individual person in the world has, needs or wants, and that’s the total “wealth” of the world. Not simple at all, is it?
Short answer: it’s like the stock market where gains and losses must cancel out. If you gain 2 doubloons on a “trade” (intentional or accidental) than it’s because the bank “lost” 2 doubloons on that same trade.
Long answer: Actually it’s even more that way in currency trading, because in the stock market profitable businesses can increase net value in society, but currency fluctuations are totally zero-sum, and can even be argued to reduce value due to dead weight losses from volatility. (Although normally that’s not an amount worth worrying about. Also, “dead weight losses” are hard to eli5)
Another thing: the “lost value” or “gained value” in some abstract sense happens to everyone who has the currency which lost or gained value – if you have doubloons, and more people want to trade other currencies for doubloons, everyone who has doubloons has “gained” value (because more people want the thing they have). This is exactly equal to a “loss” in value in all the currencies that people are willing to trade away to get doubloons. This is a kind of “virtual” gain in value though, in the same way tha having a stock that gains in value isn’t “real” until you sell the stock for cash. (I mean… It sort of is real, and it sort of isn’t… That’s also complicated to eli5.)
This can be hard to grasp because the overall price is an aggregate of lots of different people trading currency back and forth, and what they’re willing to trade for. It’s hard to personify down to the level of individual people without losing some of the context.
If you want a personal example though, maybe think about trading cards? Let’s say that you have pokemon cards, and two kinds of pokemon cards you could have are Pikachu cards, and Eevee cards. Your friend really likes Eevee cards, and will always trade you 2 Pikachu cards, for every Eevee card you are willing to trade to him. The “exchange rate” is 2 Pikachu cards, for 1 Eevee card, or to say it another way, 0.5 Eevee cards per Pikachu card.
Later on your friend decides they don’t like Eevee cards as much, or they have amassed a big enough stash of Eevee cards, or whatever… Anyway they decide that they’re only willing to trade 1 Pikachu card, for each 1 Eevee card you give them. The exchange rate is now 1 to 1. In practical terms, this means that each Eevee card lost value, and each Pikachu card gained value, in a ratio that exactly balances.
If you never trade your friend another Eevee card at this new exchange rate though, that price can be argued to be “imaginary” in some sense, because it’s not being realized through an actual trade. It doesn’t really matter to you if your Pikachu cards are “more valuable” in some hypothetical future trade, if that trade never happens. Maybe your friend only offers a 1-to-1 trade for a week, then goes back to offering a 2-to-1 trade the next week, for example… Now your Pikachu cards are worth 0.5 Eevee cards again. Does it matter to you that for a brief moment they were “worth” more?
You can build up the complexity of this example to start to reach the level of complexity of currency markets. For example, let’s say there are also Bulbasaur cards now, and initially your friend says they will trade 1 Bulbasaur card for each 1 Pikachu card, or Eevee card you have. Immediately you might see the opportunity: you can trade a Bulbasaur for an Eevee, trade the Eevee for 2 Pikachu, then trade 2 Pikachu for 2 Bulbasaur and repeat until you have all the cards. (Or all the cards of one type anyway, but lets not get lost in specifics). Your friend quickly realizes this is unsustainable, and changes his mind; now he will only trade 1 Bulbasaur for 2 Pikachu. This is an example of how multiple currencies need to “balance” against each other, to avoid runaway arbitrage opportunities. (This balancing usually happens naturally, due to different feedback mechanisms – mostly mechanisms directly and indirectly caused by people taking advantage of arbitrage opportunities).
So now… If you have Eevee cards that are worth 2 Pikachu cards, and Bulbasaur cards that are worth 2 Pikachu cards, and Eevee cards and Bulbasaur cards trade 1-to-1… What happens to the “value” of Bulbasaur cards if your friend decides to trade only 1 Pikachu for 1 Eevee card again? Now you have an arbitrage opportunity in the other direction: you can trade a Bulbasaur for 2 Pikachu cards, then trade for 2 Eevee cards, then trade to get 2 Bulbasaur cards, repeat until you have all the cards.
This means that the “value” or “exchange ratio” of Bulbasaur cards in terms of Eevee cards must change to 1-to-1, even if nothing has really changed about Bulbasaur cards, or how much people want them intrinsically (ie your friend likes Bulbasaur just as much as he did yesterday). Currency prices are always relative prices, and the relative price can change based on other exchange rate changes that are only indirectly related. This still matters in a sense to people who have Bulbasaur cards, because their Bulbasaur cards “lost value” relative to Pikachu cards, because Pikachu cards gained value relatively to Eevee and Bulbasaur cards… So their Bulbasaur cards are relatively less valuable.
If someone always “loses” and someone always “wins” in a currency trade though… Why do people still trade currency? Why don’t all currencies stabilize to one “equilibrium value” that everyone is happy with, and then never change again?
Because life is more complicated than that, and things happen outside of currency markets, which cause people to want certain currencies more or less. In Pokemon card terms, let’s say your friend opens a booster pack and gets a Riachu card. (The evolution of Pikachu). Now Pikachu cards are more valuable to him, because he needs more Pikachu cards if he wants to be able to use his Raichu card in a card battle. This is similar to companies needing local currency to build a factory, or w/e in a certain country; although the company is going to “lose” value trading their home currency for the local currency, it might still be worth it to them to do so, because the value they’ll gain from building the factory is still much higher. (Or on an individual level, maybe you need to pay 2 doubloons more for your streaming service next month, but you still do it because the steaming service is still worth more to you than the higher price.)
You tell your bank “hey, send this person 1 USD”.
The bank tells the other person’s bank “hey, I’ll send you 1 USD, but it’s a Saturday and we’re both closed”.
The other person’s bank says “no worries mate, just send it on Monday, and we’ll add a dollar to the other person”.
Your bank takes the money out of your account, let’s say 84 Yen. They don’t actually do anything with it though, it just sits there waiting until Monday because they can shift money within their systems but not into someone else’s system.
Monday rolls around, and something happened to change the exchange rate so now it only takes 82 Yen to buy 1 dollar. They buy that dollar and send it to the other person’s bank.
There’s 2 Yen left over. They took it out of your account, but didn’t use it to buy that dollar. In this case, the bank returns it to you.
The refund comes as a result of the delay between when you told them to send the money and when they actually sent the money. It’s not quite accurate to say someone else lost here, because it’s not really that simple.
>Suppose I pay for the service when $1 = 84 units of my currency, and later get a refund when $1 = 82 units. Because my currency strengthened, I’d get back more local currency than I originally paid.
Strengthened? Your example is making my brain hurt. Looks to me like you got less back.