exchange rate volatility and risk

8/3/2019 Exchange Rate Volatility and Risk

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Exchange Rate Volatility

The most important characteristic of alternative exchange rate systems is the feature used to

describe them, namely fixed or floating. Fixed exchange rates, by definition, are not supposed to

change. They are meant to remain fixed for, ideally, a permanent period of time. Floating ratesdo just that, they float up and down, down and up, from year to year, week to week, and minute

by minute.

Since fixed exchange rates are not supposed to change by definition they have no volatility. A

floating exchange rate may or may not be volatile depending on how much it changes over time.

However, since floating exchange rates are free to change, they are generally expected to be

more volatile.

Volatility represents the degree to which a variable changes over time. The larger the magnitude

of a variable change, or the more quickly it changes over time, the more volatile it is. Volatileexchange rates make international trade and investment decisions more difficult because

volatility increases exchange rate risk. Exchange rate risk refers to the potential to lose money

because of a change in the exchange rate.

Volatility example:

First consider a business that imports soccer balls into the US. Suppose 1000 soccer balls

purchased from a supplier in Pakistan costs 300,000 Pakistan rupees. At the current exchange

rate of 60 Pakistan Rs/$ it will cost the importer $5000 US dollars or $5 per soccer ball. The

importer determines that transportation, insurance, advertising and retail costs will run about $5per soccer ball. If the competitive market price for this type of soccer ball is $12, he will make a

$2 profit per ball if all balls are sold.

Suppose the shipment is scheduled to occur in 3 months and that payment for the shipment need

not be made until that time. Let's assume the importer waits to convert currency until the

payment is made and that in 3 months time the Pakistan rupee has appreciated to a new value of

55 Pakistan Rs /$. The shipment cost in rupees remains the same at 300,000 Pakistan Rs, but the

dollar value of the shipment rises to $5,454 or $5.45 per soccer ball. Assuming the same $5 of

extra costs and a $12 final sale price, the importer will now make only $1.45 profit per soccer

ball, if all balls are sold. While this is still a profit, it is about 25% less than expected when the

decision to purchase was made 3 months prior.

Thus fluctuating exchange rates make it more difficult for investors to know where to invest.

One cannot merely look at what the interest rate is across countries, but must also speculate

about the exchange rate change. Make the wrong guess about the exchange rate movement and

one could lose a substantial amount of money.


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Determinants of Exchange Rates

The following are some of the principal determinants of the exchange rate between two

countries.

1. Differentials in Inflation

As a general rule, a country with a consistently lower inflation rate exhibit a rising currency

value, as its purchasing power increases relative to other currencies. During the last half of

the twentieth century, the countries with low inflation included Japan, Germany and Switzerland,

while the U.S. and Canada achieved low inflation only later. Those countries with higher

inflation typically see depreciation in their currency in relation to the currencies of their trading

partners. This is also usually accompanied by higher interest rates.

2. Differentials in Interest Rates

Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest

rates, central banks exert influence over both inflation and exchange rates, and changing interest

rates impact inflation and currency values. Higher interest rates offer lenders in an economy a

higher return relative to other countries. Therefore, higher interest rates attract foreign capital

and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if

inflation in the country is much higher than in others, or if additional factors serve to drive the

currency down. The opposite relationship exists for decreasing interest rates that is lower interest

rates tend to decrease exchange rates.

3. Public Debt

Countries will engage in large-scale deficit financing to pay for public sector projects and

governmental funding. While such activity stimulates the domestic economy, nations with large

public deficits and debts are less attractive to foreign investors. A large debt encourages

inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper

real dollars in the future. Finally, a large debt may prove worrisome to foreigners if they believe

the country risks defaulting on its obligations. Foreigners will be less willing to own securities

denominated in that currency if the risk of default is great then country's debt rating is a crucial

determinant of its exchange rate.

4. Terms of Trade

A ratio comparing export prices to import prices, the terms of trade is related to current accounts

and the balance of payments. If the price of a country's exports rises by a greater rate than that of

its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater

demand for the country's exports. This, in turn, results in rising revenues from exports, which
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provides increased demand for the country's currency. If the price of exports rises by a smaller

rate than that of its imports, the currency's value will decrease in relation to its trading partners.

5. Political Stability and Economic Performance

Foreign investors inevitably seek out stable countries with strong economic performance in

which to invest their capital. A country with such positive attributes will draw investment funds

away from other countries perceived to have more political and economic risk. Political turmoil,

for example, can cause a loss of confidence in a currency and a movement of capital to the

currencies of more stable countries.

IMPACT

Trade flows

The relationship between exchange rate volatility and trade is well established. The basic idea is

the following if commodity traders are risk averse (or even risk neutral), higher exchange rateuncertainty may lead to a reduction in the volume of trade because they may not want to risk

their expected profits from trade. As long as there is uncertainty, economic agents will demand a

higher price to cover their exposure to currency risk, and this, in turn, will decrease the volume

of trade.

Foreign direct investment

Currency volatility may also affect developing countries through its effects on foreign direct

investment inflows. Greater exchange rate volatility increases uncertainty over the return of a

given investment. Potential investors will invest in a foreign location only as long as the

expected returns are high enough to cover for the currency risk. Thus, foreign direct investment

will be lower under higher exchange rate volatility.

And changes in the bilateral real exchange rates of the major currencies will have an immediate

impact on the real wealth of the country. Changes in their bilateral real exchange rate affect their

real wealth, and this may have a direct impact on the amount and direction of foreign direct

investment. It may increase or decrease foreign direct investment depending on which currencies

are appreciating or depreciating. The final effect will also depend on the relevance of Foreign

Direct Investment on the source countries and on the wealth elasticity of Foreign Direct

Investment on the different source countries.

Currency crises

Exchange rate instability may have contributed mainly based on the observation that preceded

the crises the dollar had a large and relatively rapid appreciation. As a result, all the currencies

that were then hanged to the dollar also appreciated. This deteriorated the relative price

competitiveness of countries. However, the effects on developing countries with exchange rates

that were pegged to other currencies experienced the opposite effects. In this sense, it is


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important to emphasize that some arguments against exchange rate volatility usually criticize not

the volatility itself, but a continuous change of one currency in certain direction.

Debt servicing costsOne of the most important effects of exchange rate movements on developing countries refers to

the external debt burden. Most developing economies are net debtors and, in consequence,

changes in the exchange rates may affect the real cost of servicing their debts. A strong

appreciation of the dollar, for example, implies a higher cost of servicing an external debt that is

mainly thus denominated. Although the impact of changes in the exchange rates on developing

countries is not in a single direction.

Summarizing, exchange rate changes may affect developing countries in different ways

depending on their debt denomination and on which of the major currencies they are more

closely connected to. Most of these channels, however, are more related to the levels in the

parities than to the volatility or uncertainty associated to them. Exceptions are the trade andforeign direct investment channels which suggest that real exchange rate volatility may indeed

reduce both types of flows to developing countries. In the following the stylized facts on

exchange rate volatility will be described, before it will be tested empirically whether these

channels have indeed affected developing countries in the recent past, and whether exchange rate

volatility has had any influence on increasing the probability of currency crises in developing

countries.

Conclusion:

The exchange rate of the currency in which a portfolio holds the bulk of its investmentsdetermines that portfolio's real return. A declining exchange rate obviously decreases the

purchasing power of income and capital gains derived from any returns. Moreover, the exchange

rate influences other income factors such as interest rates, inflation and even capital gains from

domestic securities. While exchange rates are determined by numerous complex factors that

often leave even the most experienced economists flummoxed, investors should still have some

understanding of how currency values and exchange rates play an important role in the rate of

return on their investments.

Volatile exchange rates make international trade and investment decisions moredifficult because volatility increases exchange rate risk.

Volatile exchange rates can quickly and significantly change the expected rates ofreturn on international investments.

Volatile exchange rates can quickly and significantly change the profitability ofimporting and exporting.
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REFERENCES:

http://www.apecscmc.org/2011/Documentations/S2_ShengYungYang.pdf

IMF working paper

http://wiki.answers.com/Q/Explain_the_major_factors_that_influence_the_kind_of_exchange_ra

te_system_a_country_has#ixzz1gR6HF2eU

http://www.jstor.org/pss/3867353
http://www.apecscmc.org/2011/Documentations/S2_ShengYungYang.pdfhttp://wiki.answers.com/Q/Explain_the_major_factors_that_influence_the_kind_of_exchange_rate_system_a_country_has#ixzz1gR6HF2eUhttp://wiki.answers.com/Q/Explain_the_major_factors_that_influence_the_kind_of_exchange_rate_system_a_country_has#ixzz1gR6HF2eUhttp://wiki.answers.com/Q/Explain_the_major_factors_that_influence_the_kind_of_exchange_rate_system_a_country_has#ixzz1gR6HF2eUhttp://wiki.answers.com/Q/Explain_the_major_factors_that_influence_the_kind_of_exchange_rate_system_a_country_has#ixzz1gR6HF2eUhttp://www.apecscmc.org/2011/Documentations/S2_ShengYungYang.pdf

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