Foreign exchange rates are an important way of measuring a country’s economic health, and a great way to assess the suitability of an economy for business expansion. This is why the exchange rate markets are so closely watched.
But what influences movements in exchange rates? And more, what makes them ‘volatile’? That word gets thrown around a lot in the foreign exchange space, but what does it mean?
Exchange rate volatility refers to the tendency for foreign currency to appreciate or depreciate in value and ultimately affects the profitability of a trade (or transfer) overseas.
Now that we understand what volatility is, what common factors influence it? Let’s break it down below:
1. Inflation rates
Inflation rates impact a country’s currency value. A low inflation rate typically exhibits a rising currency value, as its purchasing power increases relative to other currencies. Conversely, those with higher inflation typically see depreciation in their currencies compared to that of their trading partners, and it’s also typically accompanied by higher interest rates.
Government debt also plays a part in inflation rates. A country with government debt (public or national debt owned by the central government) is less likely to acquire foreign capital, leading to inflation.
2. Interest rates
Exchange rates, interest rates and inflation rates are all interconnected. An increase in interest rates cause a country’s currency to appreciate, as lenders are provided with higher rates and thereby attracting more foreign capital. This can cause a rise in the value of a currency and therefore the exchange rate. Cutting interest rates, on the other hand, can lead to a depreciation of the currency.
*The image above is provided for general information purposes only and is not an accurate representation of the live exchange rate.
3. Monetary policy and economic performance
If a country has a history of strong economic performance and sound monetary policy, investors are more inclined to seek out those countries. This inevitably increases the demand and value of the country’s currency.
With the state of the global economy at the time of writing, it’s evident that we’re in a global slowdown and fears of recession are looming. A recession may also cause a depreciation in the exchange rate because interest rates usually fall, however, this isn’t always the case.
Other recession factors that can influence currency value include the determent of foreign investment, which would decrease the value. However, if a recession causes inflation to fall, this helps a country become more globally competitive and demand for the currency becomes greater.
Let’s use the US as an example here. If someone travels outside the US to another country, they will get more from a money transfer to that country when the USD appreciates against the foreign currency. Similarly, depreciation of a currency means that foreigners will be more inclined to visit that country and spend more while there.
Another factor here are ‘visitor-weighted exchange rates’, which measure a destination’s currency market with those of its primary visitor market. In essence, countries that have a diversified range of visitor markets tend to be more resilient against specific exchange rate margins, compared to those who rely on specific visitor markets.
5. Geopolitical stability
The political state of a country, coupled with economic performance, can also affect the strength of the currency. A country with less risk for political turmoil will be more attractive to foreign investors, leading to an appreciation of the value of its domestic currency from foreign capital.
‘Geopolitical risk’ is the risk posed to foreign investors by unexpected political developments. If a country’s economy and political landscape remains predictable, investors are more likely to buy the currency. The opposite effect is also true, unexpected events lead investors to pull their money back, sending the currency down in value.
The impact of Hong Kong’s Extradition Bill is an example of this in recent times. The bill, also known as the ‘fugitives bill’, would enabled almost anyone who enters Hong Kong – whether in transit, to visit or as a resident – to be extradited to China or any other jurisdiction that Hong Kong does not have an extradition treaty with. The fear is that even multinational executives could be held and removed to a foreign country, whether the charges are unfounded or not.
Despite the protests following prompting the bill to be suspended, the fact that it has not been thrown out altogether creates ongoing uncertainty for businesses and investors in the region, which could potentially see an impact on the Hong Kong dollar.
6. Import and export value
A country’s balance of payments (BOP) summarises all international trade and financial transactions made by individuals, companies and government bodies complete with those bodies of that country. These transactions can consist of imports and exports of goods, services and capital.
The reason BOP is included here is that it influences the ratio comparing export prices to import prices. If the price of a country’s exports are greater than their imports, its ‘terms of trade’ have improved. This creates a greater demand for that country’s exports, and in-turn, greater demand for the currency.
Like many of the other factors influencing exchange rates, the converse reaction can also occur. If the exports rise by a smaller rate than the imports, the value of that country’s exports and currency decrease in value.
What can you do to make volatility work for you?
Now that we know what influences the markets, you’re already far more prepared than the majority. From here, you can use these factors to your advantage when planning a currency strategy that uses any potential volatility to your advantage.
For example, by partnering with a global money transfer specialist, such as OFX, when dealing in different currencies around the world, you can take advantage of tools designed for that specific purpose.
Forward Exchange Contracts for example, allow you to lock in an exchange rate if it suits your transfer needs and then transfer the funds at a later date, even up to 12 months in the future. For example, if you needed to transfer money from USD to GBP and the GBP drops drastically, like it did when the Brexit referendum outcome was announced, a Forward Exchange Contract may help.
OFX also offer other tools that can help you manage your global money transfer needs. See how they compare below:
|Spot Transfer||Limit Order||Forward Exchange Contract|
|Transfers money as a single exchange||Allows you to lock in a target rate and we market-monitor for you||Lock in a favourable rate and transfer later|
|Uses the rate secured at the time of transfer||Can cancel at anytime, or roll into an FEC||Can be used for up to 12 months|
|Great for everyday transfers and risk management||Helps mitigate risk in uncertain markets||Good for sensitive pricing schedules|
So while volatility may sound like a bad thing, it doesn’t have to spell the end of a businesses international expansion. With the right help and tools, you can develop a currency strategy that takes into account how volatility can be favourable, rather than feared, providing you with the confidence to dive headfirst into the next market.
IMPORTANT: The contents of this blog do not constitute financial advice and are provided for general information purposes only without taking into account the investment objectives, financial situation and particular needs of any particular person. UKForex Limited (trading as “OFX”) and its affiliates make no recommendation as to the merits of any financial strategy or product referred to in the blog. OFX makes no warranty, express or implied, concerning the suitability, completeness, quality or exactness of the information and models provided in this blog.