Exchange rates hold very high importance for businesses with international operations. Any fluctuations in exchange rates can cause a major adjustment in the financial position of the foreign subsidiary of a company. It is highly important for such companies to identify the factors that influence exchange rates and to develop a risk mitigation plan.
Factors Influencing Exchange Rates
Following are the factors that influence exchange rates:
The prevailing rate of inflation in a country directly influences its exchange rate. If the rate of inflation rises, it depreciates the value of the currency making it weaker against foreign currencies. The rate of inflation is influenced by numerous economic factors such as; economic growth, fiscal policy of the country and the monetary policy of the country.
Interest rates are also influence the exchange rate. The mechanism that is at work here is; rise in interest rates encourages the investors to invest and this causes a rise in the overall economic activity in the country. Due to the increased economic activity, the inflation rate also rises and resultantly the currency depreciates causing a rise in the exchange rate against other currencies in the world.
Exchange rate is influenced by the demand for the currency and the demand rises only when there are a large number of foreign businesses involved in business transactions with the country. If there is no political stability in a country, the economic situation of the country remains uncertain, and the foreign businesses will avoid having any relations with the country due to economic uncertainty. This causes a lack in demand for the currency causing depreciation in its value.
Exchange Risk Mitigation
These fluctuations can also cause significant loss to the company if the changes in the exchange rates are unusually significant. Therefore, it is important for a business to develop an exchange management program in order to minimize the impact of the changes in the exchange rates on the financial performance of the company. Following are some of the aspects involved in the exchange risk mitigation program:
The very first step in the exchange management program is the evaluation of the trend of the exchange rates. A comprehensive analysis is required to be done in order to predict the future trend of the exchange rates. The analysis will include a consideration of all the factors that influence the exchange rates including the trend of historic exchange rates. The policies specific to the countries will also have to be assessed and any possibility of the policies being modified in the near future will also have to be accounted for.
Hedging through Financial instruments
Hedging is one of the most effective tools against minimization of exchange rate risk. Hedging can be done by acquiring different financial instruments. There are a number of derivatives that are structured differently and they have different foundations. The business can use forward currency contracts, currency options, or foreign currency borrowing as hedging tools in order to minimize the risk of fluctuating exchange rates.
Thus, it can be concluded that there are multiple factors that influence exchange rates and it is highly important for a business with international presence to address these fluctuations. The risk related to exchange rates can be mitigated through exchange forecasting and hedging.