Exchange Rates Volatility and Risks Essay

There are a number of factors that could change the value of a currency with respect to another. If the inflation rate in a country is low with respect to the inflation rate in other countries, the prices of goods and services in the country with the low inflation rate become attractive for foreigners. However, increases in demand for the goods and services in the country with a low inflation rate are expected to appreciate the value of the country’s currency (Ana, FS 2004). Changes in interest rates tend to have a similar affect on exchange rates. Foreigners would like to invest in countries where the rates of return on investment are high. As the demand for investment in a particular country increases – because it enjoys a high interest rate in comparison with other countries – the value of its currency is expected to appreciate (Ana, FS). The exchange rates at a given time are also dependent on differences between the current account balances of countries. If a country is running a current account deficit, it generally means that the country is importing more than it is exporting, so therefore investments in the country may not be considered lucrative. A country with a current account surplus, on the other hand, is considered attractive for investment. As a matter of fact, the currency of this country is as attractive to foreigners as its products and services. By increasing their demand for the country’s products and services, foreigners are expected to appreciate its currency’s value. As its currency’s value appreciates, however, investing in the country becomes less affordable (Ana, FS). When a country is experiencing a current deficit, its government may decide to borrow money to finance the self same deficit. Inflation may ensue. Moreover, if the lenders believe that there is a default risk, they may decide to sell off the debt on the open market. In the United States, treasury securities may be used for this reason. In any case, the selling of the debt on the open market is expected to exert downward pressure on the foreign exchange rate (Ana, FS). Exchange rates are also affected by the political climate of a country at any given time. Political disturbance in a country may result in a loss of investor confidence in its currency. Conversely, countries that enjoy relatively stable political climates are able to attract investment and experience appreciations in the values of their currencies (Bergen, JA 2007). Undoubtedly, a firm must be able to manage the different kinds of political risks that it may have to face by investing in a particular country. There are three main types of political risks: firm-specific risks, country-specific risks, and global-specific risks. Of the three types of political risks, firm-specific risks include the volatility of exchange rates. These risks are expected to affect the multinational enterprise at the corporate and/or project level (Frenkel, M, Karman, A, & Scholtens, B 2004). For this reason, an exchange rate risk or currency risk – from the perspective of an American investor – is defined as follows: The risk that a business’ operations or an investment’s value will be affected by changes in exchange rates. For example, if money must be converted into a different currency to make a certain investment, changes in the value of the currency relative to the American dollar will affect the total loss or gain on the investment when the money is converted back. This risk usually affects businesses, but it can also affect individual investors who make international investments (Exchange Rate Risk 2007). There are three types of exposure to exchange rate volatility that an investor may have to confront. The firm faces translation exposure when its reported accounting profits must be adjusted as a result of foreign exchange rate fluctuations. Transaction exposure is the result of the firm’s agreement to undertake certain â€Å"foreign exchange transactions during the current period (Bolster, P 2006). † As an example, an importer may sign an agreement to purchase a specific quantity of goods from Country A and pay a certain amount of money to the country in ninety days. Through this agreement the importer is obligated to pay Country A by purchasing the units of Country A’s currency in ninety days. Seeing that the exchange rate may change in ninety days, the importer is exposed to currency risk (Bolster, P). Lastly, investors may have to face economic exposure to exchange rate volatility. This type of exposure to exchange rates volatility results from the need of the firm to conduct business activities in another country in future. Bolster, P describes economic exposure as â€Å"the need for foreign exchange transactions and exposure to exchange rate fluctuations that results from future business activities. † The experience of Toyota in the U. S. utomobile market helps to explain this type of exposure to exchange rate volatility. The company had managed to attain a sizeable market share in the United States. But, when the Japanese yen started to appreciate in relation to the U. S. dollar, the revenues of the company dropped significantly (Bolster, P). The good news is that it is possible for investors to manage the political risks, including the firm-specific risks that they may be exposed to. â€Å"Limiting, diversifying, and hedging† are all viable methods of managing political risks (Frenkel, M, Karman, A, & Scholtens, B p. 20). †