How foreign exchange volatility impact to the companies?

How foreign exchange volatility impact to the companies?

Foreign exchange volatility

‘Foreign exchange volatility as known as ‘Currency volatility’, is the uncertain changes of exchange rates in the global foreign exchange market. The volatility of foreign exchange can subject to huge losses (or gains) in international trade.

 The foreign exchange market is the place where foreign currencies are traded and it is the biggest financial market today, where the exchange rates are determined by the demand and supply.

The exchange rate is, expressing the value of one country’s currency in relation to another currency. For example, how many US dollars does it want to buy one euro.

Key Factors influence foreign exchange volatility

The level of inflation, interest rates, tourism industry, political stability, monetary policy, and import and export levels are the main factors for the creation of volatility.

Why a company should consider foreign exchange volatility?

A company that facilitates the trade of goods and commodities between domestic and foreign companies should be engaged with import and export activities. So it must pay close attention to the exchange rates because volatile exchange rates can change the profits of import and export activities, rapidly and outstandingly. Apart from that volatile exchange rates can damage the expected rates of return on international investments notably. There are main two types of changes in the exchange rate which directly affect international trade including exports and imports. They are ‘currency depreciation’ and ‘currency appreciation.

How does the currency depreciation impact a company?

In a currency depreciation, the worth of the currency falls in terms of its exchange rates versus other currencies. A depreciation makes exports cheaper and because of that, exporting firms will benefit. But imports become more expensive in this case. Currency appreciation is the opposite side of depreciation.

How does currency appreciation impact a company?

In a currency appreciation, the value of one currency increases in relation to another currency. An appreciation makes imports cheaper and because of that importing firms will benefit. But exports become more expensive and appreciation reduces the competitiveness of exporting firms. (www.bing.com, n.d.). As a result of this, a company that facilitates the trade between domestic and foreign companies has both positive and negative effects of these changes. The company must manage it effectively and gain profit at the correct time.

What types of risk are created by foreign exchange volatility?

Foreign exchange volatility creates different types of risks. Volatility shows how much a variable can change over time. The volatility of exchange rates makes international trade and investment decisions harder, because exchange rate risk increases, as a result of volatility. Foreign exchange volatility is the basic cause of foreign currency risk and it has become a growing concern in multinational businesses. Foreign exchange risk can be created, when fluctuations in the exchange rates between currencies affect the business’s financial performance in a bad manner. So, any appreciation or depreciation of the base currency or denominated currency will directly and significantly affect the trade and cash flows of the transactions. So, this is related to the losses that may happen due to currency fluctuations

There are three types of risks that are faced by the companies; Transaction risk, Economic risk, and Translation risk

Transaction risk

Transaction risk is the risk faced by the company when it’s buying a product from a company located in another country. If the seller’s currency appreciates versus the buyer’s currency, then the buyer will have to make a larger unexpected payment in their domestic currency to settle the transaction. Transaction risk may increase when the time gets longer between entering a contract and settle down it. So, there are more chances for the currencies to fluctuate

As an example; we can assume that a US company signs a contract with a European country to buy some products from them. It will take few months for delivery and at that time dollar depreciates versus Euro. Because of this, the US Company has to pay more than they expected at the contracted price. This is a huge loss for the company.

Economic risk

Economic risk refers to how a company’s market share is impacted by an unpreventable revelation to currency fluctuations and shifts in economic conditions. Macroeconomic conditions like exchange rates, government decisions, and geographical and political stability create this risk. Because of this risk, international investments become riskier than domestic investments. Economic risk adversely affects the resource contributors like shareholders of the company.

Translation risk

Translation risk refers to a situation where a mother company has a branch in another country but that mother company gets back the branch’s revenue or profit at a lower level. This also creates risk because the volume of currency to translate back to the reporting currency may be change.

How to manage risks of the foreign exchange volatility?

These are the three types of risks that a company has to face while trading between domestic and foreign companies. The risk affects the company because it trades in international markets and doing business with domestic and foreign companies. But the company can manage the exchange risk by identifying the type of risk and how much the company can tolerate in volatile currency markets Companies who face foreign exchange risk can implement hedging strategies like forwarding contracts, options, and exotic financial products to mitigate that risk

Choosing a type of exchange rate is also important in foreign exchange volatility. Floating exchange rates and fixed exchange rates are the main two types of exchange rates. Floating exchange rates change regularly according to the market condition and would be riskier than fixed rates. This may lead to foreign exchange volatility and countries, that wish to reduce volatility, choose fixed exchange rates. But most exchange rates are free-floating in open economies and behaving based on supply and demand in the exchange market.

Conclusion

According to this explanation, it is easy to understand that a company that facilitates trade between domestic and foreign companies may quickly and significantly be affected by the fluctuations of the exchange rates. In this globalized world, economies and business firms can’t survive alone and they have to participate in global economic activities. Both foreign and domestic companies have direct and indirect effects of unexpected fluctuations of exchange rates. Currency appreciation, currency depreciation, and exchange rate risks are the main effects which are created by the exchange rate volatility.

When volatility adversely affects the economy, governments impose barriers on the buying and/or selling the currencies. A government can limit the use of particular foreign currency, impose fixed rates to discourage speculation, or restricting the amount of currency that can be imported to or exported from the country. These controls help countries to stabilize their economy and companies to carry on their business to earn more profits. So, foreign exchange volatility plays a vital role in international trade and the economy. Foreign exchange volatility is a natural outcome of the exchange market process. The firms have to manage it well and avoid negative outcomes.

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