The term “local currency” refers to the official currency of a country which is legally accepted for all financial transactions within that country. It is also known as “domestic currency.”
Each country usually has its own unique currency. For instance, the United States uses the U.S. dollar (USD), the United Kingdom uses the pound sterling (GBP), Japan uses the yen (JPY), and so on.
There are exceptions, however. For example, in the Eurozone, which consists of 19 of the 27 member countries of the European Union, the local currency is the euro (EUR). Another example is Ecuador, which despite being a sovereign nation, uses the U.S. dollar as its local currency due to economic circumstances.
In financial markets, the term “local currency” is often used to differentiate from foreign currencies or hard currencies like the U.S. dollar, euro, or British pound. For instance, an investment denominated in local currency means that the investment is priced and pays returns in the currency of the country where the investment is located. This exposes the investor to currency risk, as changes in the exchange rate between the local currency and the investor’s home currency can affect the value of the investment.
Example of the Local Currency
Let’s take an example of a tourist visiting Japan from the United States.
- Local Currency: When the tourist arrives in Japan, he’ll need to use the local currency, which is the Japanese yen (JPY), to pay for expenses like hotel rooms, meals, transportation, and souvenirs. Even though his home currency is the U.S. dollar (USD), it’s typically not accepted for transactions in Japan.
- Currency Exchange: The tourist will need to exchange some of his dollars for yen, which he can do at a bank or currency exchange service. The rate at which he can exchange his dollars for yen is determined by the foreign exchange market. If the exchange rate is 110 yen to the dollar, for example, then $100 would give him 11,000 yen.
- Currency Risk: If the tourist has leftover yen at the end of his trip and wants to exchange it back into dollars, he might get more or less than he originally paid, depending on how the exchange rate has changed. This is an example of currency risk. If the exchange rate has changed to 100 yen to the dollar, for example, then his 11,000 yen would now be worth only $110. But if the exchange rate has changed to 120 yen to the dollar, then his 11,000 yen would now be worth only about $91.67.
This example shows how the concept of local currency is relevant for international travel, and it also illustrates the related concepts of currency exchange and currency risk. In financial markets, similar principles apply when investors from one country invest in another country, as they typically need to convert their home currency into the local currency of the country where they are investing.