The global foreign exchange market is a highly dynamic, and sometimes volatile, environment. In markets such as these, conditions can change rapidly and create far reaching impacts for traders, investors and businesses alike.
While daily currency fluctuations are a normal part of the FX market, few people take the time to question and understand why this volatility occurs or what, if anything, they should do in response. Indecision or lack of attention in this space represents a risk to the profitability of investors or businesses that face currency exchange or global payments challenges.
This article will provide an overview of some of the interrelated market forces that drive foreign currency prices, and explain how they can affect the bottom line of your Canadian or international business.
What Determines a Currency’s Value?
In today’s economy, currencies are freely traded with flexible exchange rates. The price movement of global currencies depends upon various foreign exchange market forces, themselves the result of market supply and demand.
Just as prices on the stock market increase when demand for a particular stock is high or supply is low, so do currency values. On the flip side of the coin, a decrease in demand (or an increase in supply) will lower the price of a given currency.
Foreign exchange market conditions can be strongly influenced by a number of factors, including:
- Each country’s monetary policy
- Their respective interest rates and inflation rates
- Interrelated global, regional and national economic climates
- The degree of volatility in global, regional and national political conditions
These familiar but complex forces are constantly at work in free-market economies, and are sometimes taken for granted. For this reason, it's worth taking a step back to examine the underlying causes for these forces.
Why? Because currency fluctuations can affect your business and your investments more than you might think, which is why so many businesses use some form of currency exchange or global payments solution.
Monetary policy is the mechanism through which a nation ensures price and currency stability within its borders. National central banks will use adjustments in interest rates and the money supply to do so. Both monetary policy and the interest rates set by central banks have an influence on the rate of inflation, which has consequences for currency fluctuations.
With an increase in the money supply, a currency becomes more accessible, often leading to a lower cost of borrowing through low interest rates. As businesses and individuals take advantage of so-called “cheap money'' by increasing their borrowing and spending, the result is often a period of economic growth. However, this increase in the money supply and the corresponding changes in the interest rate can also lead to inflation.
Interest & Inflation Rates
Stated simply, inflation is the rate at which the price of goods and services increases. A certain amount of inflation is normal, and even expected. However, too much inflation can undermine economic stability by causing a rise in prices.
With higher prices for goods and services, each unit of currency is weaker as a result. The reduction in the purchasing power of money reflects a loss in real value of the medium of exchange within an economy, which can ultimately lead to a currency’s decline in value on the international stage.
Central banks constantly walk a tightrope between spurring and slowing economic activity, and they do so by tweaking the prime interest rate in response to inflation data, which gives rise to several different dynamics.
When a central bank tamps down inflation rates by increasing interest rates, it discourages spending and favours saving. This shift can actually increase the demand for a particular currency and drive up its price. On the other hand, lower interest rates tend to lead to lower currency values. This isn't necessarily a bad thing, however, as low interest rates often lay the foundation for long-term economic growth.
Political & Economic Considerations
Other major factors affecting currency volatility and the exchange rate are the broader political and economic conditions or events within a country or region.
Political uncertainty can be deeply threatening to investment flows because most investors crave predictability and stability. Because they are considered a safer destination for investment, currencies from countries with a history of political and economic stability are usually in higher demand and have higher exchange rates. Currencies like the U.S. and Canadian dollar would fall into this category.
Aside from monetary policy, the interest rate and inflation rate, other economic factors within a particular country can influence foreign currency markets. This includes items such as the growth of gross domestic product, the unemployment rate and trade flows (imports & exports). The currencies of countries with strong economic indicators and high consumer confidence tend to be in higher demand.
How Currency Fluctuations Affect Businesses
Managers and executives usually have an intuitive understanding of how the volatility of currency pairs can change the value of their assets and liabilities, but the influence of exchange rates on operating profits and operating exposure is often overlooked.
Treasurers, CFOs and CEOs understand that exchange rate volatility can have a major impact on the competitiveness of certain businesses, especially those who source materials and labor internationally. Over short to medium-term time frames, currency volatility can have an exaggerated impact on operating margins.
As the world moves towards a more integrated global economy, the variation in international monetary policies affects the operating profits of many companies, even those without an international focus since they compete against foreign companies within their own domestic markets.
So what is a business to do to protect themselves from risk and boost their bottom line? Often the best decision a company can make is to consult with experts in this exact field. Both Canadian companies (and those around the world) would greatly benefit by consulting with a partner that can help them manage their global payments, foreign exchange currency risks, minimizing any risk brought on by volatility.
Should Currency Volatility Influence Investment Strategy?
Currency volatility often grabs news headlines, but that doesn’t mean that investors should make knee-jerk reactions in response.
It is extremely difficult to predict how individual currencies will fluctuate, so investors should be wary of overreacting to FX market volatility. Instead of looking at exchange rate changes in the light of improving returns, they should approach them from a perspective of reducing portfolio currency risk.
The US dollar, for example, is regarded as a safe reserve currency, one that investors flock to when economic uncertainty is on the horizon. For investors holding assets prone to high volatility, the US dollar has served as a currency asset that can actually decrease the overall risk in a portfolio.
But for investors with a long-term vision, achieving diversity means going beyond the dynamics of a particular currency pair to looking at the foreign exchange market as a whole. Currency pairs do not exist in a vacuum and it’s not always about the loonie versus the greenback. A truly diversified portfolio takes into account currency moves throughout the international markets.
Need Customized Solutions to Your Global Payments and Corporate Currency Exchange Challenges?
Global foreign exchange markets are dynamic, volatile and complex. Because businesses have a duty to protect their profits from the risks inherent in the ups and downs of international markets and economic conditions, they need a long-term strategy.
If you’re a Canadian business and want to explore how you can protect the profitability of your business, book a free consultation with the professionals at Olympia Trust - a five minute phone call could lead to a comprehensive, custom-tailored solution that could potentially save your business thousands of dollars per year and streamline operations.