Exchange rate volatility affects foreign exchange operations, commercial transactions, and international investments. It can be mitigated by using futures to fix exchange rates, but there are drawbacks to hedging against it.
Exchange rate volatility refers to the tendency of foreign currencies to appreciate or depreciate in value, which affects the profitability of foreign exchange operations. Volatility is the measure of how much these rates change and the frequency of those changes. There are many circumstances in which exchange rate volatility comes into play, including commercial transactions between parties in two different countries and international investments. Although this volatility is difficult to avoid in such circumstances, the use of futures to fix exchange rates can mitigate the effects of changing prices.
Volatility can occur in any security that increases or decreases in value. The term is most often used in conjunction with the stock market, but foreign currencies can also be volatile. When exchange rates are floating exchange rates, as opposed to fixed exchange rates, they are likely to go up and down in value depending on the strength of the economies involved. As a result, volatility is something that plagues any business venture that involves two different countries.
To see an example of exchange rate volatility in action, imagine that a company in one country decides to make a purchase from a supplier in another country. They agree on a price, even though the actual business transaction won’t happen for another six months. In the six months that pass, the currency of the provider’s country appreciates in value significantly. When the purchasing company converts its own currency into the foreign currency to purchase the quantity specified in the contract, it will have to spend more of its money to do so.
In that example, exchange rate volatility affected the purchasing company and perhaps its ability to make a profit on the supplies it purchased. But that volatility can also affect investors trying to take advantage of foreign markets. A US investor who puts his money in a foreign market to take advantage of favorable interest rates in the other country could lose if the foreign currency depreciates or the US currency appreciates during the investment term.
There are ways to hedge against exchange rate volatility, but most of these methods have their drawbacks. In foreign business transactions, one party may immediately convert their money to the foreign currency to anticipate any potential rate volatility. But that would tie up that money and prevent it from being used for domestic opportunities. Futures contracts that lock in exchange rates may prevent volatility, but that would also prevent one party to the contract from benefiting if rates move in their favor.
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