5 Factors That Affect Exchange Rate Volatility
Besides inflation and interest rates, foreign exchange rate volatility plays a crucial role in determining a country’s economic stability. Foreign exchange rates offer a reliable way to measure a country’s level of trade and if it’s suitable for business expansion.
If you’ve exchanged currencies several times before, you realize that the exchange rates keep changing. But have you ever wondered why the foreign exchange rates fluctuate? In this guide, we look at the factors that influence exchange rate volatility.
Overview of Foreign Exchange Rates
Exchange rate movements can affect a country’s trade relationship with other countries. If a country’s currency is highly valued, its imports become less expensive while its exports more costly in the foreign markets. If a country’s currency is valued lower, its imports will be more costly while its exports are less costly in foreign markets.
Key Takeaway: A lower exchange rate can be expected to improve a nation’s balance of trade, while a higher exchange rate can worsen it.
Factors Affecting the Exchange Rate Volatility
The volatility of an exchange rate is the ability of a foreign currency’s value to increase (appreciate) or decrease (depreciate). It can affect the profitability of trade overseas.
Now that you know what exchange rate volatility is, let’s look at the factors that affect it.
1. Inflation Rates
Generally, countries with consistently lower inflation rates tend to exhibit an appreciation in their currencies’ value. Their purchasing power will rise relative to other currencies.
On the other hand, countries with higher inflation rates tend to exhibit depreciation in their currency. As a result, the currency’s purchasing power reduces tremendously.
For Example
If inflation in Canada is relatively lower than in other countries, Canada’s exports will be more competitive. As a result, the demand for Canadian dollars to buy Canadian goods will increase. Foreign goods will also be less competitive, reducing imports into Canada.
2. Interest Rates
Another crucial factor that can affect a country’s currency exchange rate is the interest rate. Since both factors are correlated, an increase in interest rate can increase the value of the country’s currency. The higher interest rates will attract more foreign capital.
When the foreign capital increases, the country’s currency will increase in value. As a result, the exchange rate will increase. On the other hand, lowering the interest rates will cause the country’s currency to depreciate, decreasing the exchange rates.
Higher interest rates provide higher returns to lenders in a country relative to other countries. As a result, many foreign investors will be willing to invest in the country. Conversely, lower interest rates offer lower returns to both local and foreign lenders.
3. Government Debt
The amount of government debt can also influence a country’s exchange rate. For instance, if investors fear that a particular government may fail to pay its debt, they will sell their bonds. As a result, the country’s currency value and the exchange rate will fall.
For instance, if markets fear that Canada would default on its debt payment, the foreign investors will sell their holdings of Canadian bonds. An excellent example is the Iceland debt crisis in 2008 that caused a rapid fall in the country’s currency value.
Countries with large public debts and deficits are generally less lucrative to foreign investors. A plausible explanation is that large public debts encourage inflation. In fact, foreigners won’t be willing to invest in securities denominated by the country’s currency.
4. Terms of Trade
The terms of trade is a ratio that compares a country’s export prices with import prices. It’s related to the balance of payments (BOP) that summarizes all international trade and financial transactions made by companies, individuals, and government agencies.
We’ve mentioned BOP here because it influences the ratio that compares export values and import values.
If the prices of a country’s exports increase by a greater rate than that of its imports, then its “terms of trade” would have improved favourably. As a result, the demand for the country’s exports will rise, increasing the demand for its currency. The rising demand for the country’s currency will increase its value as well as the exchange rate.
On the other hand, if the prices of exports increase by a lower rate than that of the imports, the country’s currency will decrease in value relative to the trading partners. As a result, the demand for its currency will fall, diminishing the exchange rates.
5. Economic Performance and Monetary Policies
If a country has been recording a solid economic performance, foreign investors will confidently invest their capital in that country. By withdrawing investment funds from other countries, the country’s currency will rise in demand, raising the exchange rates.
Factors like political turmoil can result in poor economic performance. For that reason, foreign investors tend to shy away from investing in such countries. Investors will lose confidence in the currency and move their capital to countries that are politically stable.
Notably, countries with more robust economic performance usually have sound monetary policies. Foreign investors will seek to invest in such a country, increasing the demand for its currency. Consequently, the exchange rates will increase.
How to Take Advantage of Foreign Exchange Volatility
Now that you know the significant factors that can influence the volatility of exchange rates, you are far more prepared. You can use the elements to your advantage when conducting a currency exchange or international funds transfers.
There are many ways to use any potential exchange volatility to your advantage. For instance, you can partner with currency exchange providers, such as KnightsbridgeFX, that offer the lowest exchange rates for various currencies globally.
An excellent way to evade the adverse effects of volatility is by booking a forward rate. This product allows you to lock in the current exchange rates for future use at a specific date. You’ll still transact using the locked rate even when the market changes.
Final Words
Although foreign exchange rate volatility may seem alarming, it doesn’t have to stop you from expanding your business globally. With the help of a reputable currency exchange provider like KnightsbridgeFX, you can create and implement a currency strategy that considers how exchange rate volatility can be favourable.