19.1 Exchange Rate Fluctuations

Exchange rate fluctuations not only impact the decision making of both big and small trade organizations but also impact the decisions taken by governments and banks. For firms that depend on export sales, or firms that rely on imported inputs to production, or even purely domestic firms that compete with firms tied into international trade, sharp movements in exchange rates can lead to dramatic changes in profits and losses.

A central bank may desire to keep exchange rates from moving too much as part of providing a stable business climate, where firms can focus on productivity and innovation, not on reacting to exchange rate fluctuations. One of the most economically destructive effects of exchange rate fluctuations can happen through the banking system. Financial institutions measure most international loans in a few large currencies, like US dollars, European euros, and Japanese yen. In countries that do not use these currencies, banks often borrow funds in the currencies of other countries, like US dollars, but then lend in their own domestic currency. This process of borrowing in a foreign currency and lending in a domestic currency can work just fine, as long as the exchange rate does not shift. But any fluctuations in currencies may adversely impact bank operations and make a country’s banking system bankrupt (Moledina et al., 2014).

Therefore, understanding and managing exchange rate risk is of utmost importance to organizations as well as governments. Exchange rate risks can be classified by the different form of exposures such as transaction, translation, or economic exposure.

References

Moledina et.al. (2014). Principles of macroeconomics (2nd ed.). Openstax. https://openstax.org/books/principles-macroeconomics-3e/pages/16-3-macroeconomic-effects-of-exchange-rates

Attribution

“Chapter 19: Exchange Rate Risk Management” is an adaptation of “20.3 Exchange Rates and Risk” from Principles of Finance by Julie Dahlquist & Rainford Knight, published by OpenStax – Rice University and licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted. Access “Principles of Finance” for free.