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…
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 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 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 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.
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.
Foreign exchange volatility ‘Foreign exchange volatility as known as ‘Currency volatility’, is the uncertain changes of exchange rates in the…