Why does currency fluctuations

A country's terms of trade improves if its exports prices rise at a greater rate than its imports prices. This results in higher revenue, which causes a higher demand for the country's currency and an increase in its currency's value. This results in an appreciation of exchange rate. A country's political state and economic performance can affect its currency strength. A country with less risk for political turmoil is more attractive to foreign investors, as a result, drawing investment away from other countries with more political and economic stability.

Increase in foreign capital, in turn, leads to an appreciation in the value of its domestic currency. A country with sound financial and trade policy does not give any room for uncertainty in value of its currency. But, a country prone to political confusions may see a depreciation in exchange rates. When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire foreign capital. As a result, its currency weakens in comparison to that of other countries, therefore lowering the exchange rate.

If a country's currency value is expected to rise, investors will demand more of that currency in order to make a profit in the near future. As a result, the value of the currency will rise due to the increase in demand. Kuban State Agrarian University. Journal Article. Access the full text Link to PDF. Lookup at Google Scholar.

The exchange rate has direct impact on economy of any state. At the same time, markets are becoming more global. Because of these changes, exchange rates affect the operating profits of companies in globally competitive industries, whether or not they export their products. In fact, changes in exchange rates can often affect the operating profit of companies that have no foreign operations or exports but that face important foreign competition in their domestic market.

By understanding the long- and short-run behavior of exchange rates, we can understand how they affect operating profit. In the long run, changes in the nominal dollar-foreign currency exchange rates tend to be about equal to the difference between the U. If the U. This long-term relationship between exchange rates and price levels—usually called purchasing power parity PPP —implies that changes in competitiveness between countries, which would otherwise arise because of unequal inflation rates, tend to be offset by corresponding changes in exchange rates.

In the short run of six months to several years, however, exchange rates are volatile and greatly influence the competitiveness of companies selling to the same market but getting materials and labor from different countries. This short-run change in relative competitiveness results from changes in the nominal exchange rate that are not offset by the difference in inflation rates in the two countries.

This example shows that the change in relative competitiveness does not depend on changes in the nominal exchange rate—the number of deutsche marks obtained for each dollar—but on changes in the real exchange rate, which are changes in the nominal exchange rate minus the difference in inflation rates in the two countries.

Thus, in the case of the U. Because changes in real exchange rates reflect deviations from PPP, over long periods of time the cumulative change in the real exchange rate tends to be smaller than that of the nominal exchange rate. The volatility of real exchange rates in the time frame of six months to several years, however, causes an exaggerated variability in operating margin. Traditional analysis of currency exposure focuses on contractual items on the balance sheet such as debt, payables, and receivables denominated in a foreign currency whose dollar value is affected by nominal exchange rate changes see Exhibit I.

The company may enter into forward contracts to hedge this contractual exposure. A traditional analysis recognizes two types of impact on profits. One arises from translation of contractual items outstanding at year end, and the other involves transactions completed during the year.

Accounting statements contain the information required to define this contractual or accounting exposure. With the adoption of FASB 52 in , physical assets also enter into the calculation of foreign currency translation gains and losses. In general, however, these gains or losses bear little or no relation to operating exposure.

In economic terms, these contractual items are properly identified as exposed to changes in exchange rates. By hedging its contractual exposure but failing to take operating exposure into account, a company may be raising its total exposure. The company must take into account both contractual and operating exposure. Unfortunately, the difference in emphasis in considering each type of exposure tends to make practitioners defensive who are accustomed to dealing with contractual exposure, while operating managers will view it as something outside their responsibility.

It is hard to maintain a balanced perspective when the effects of changes in nominal exchange rates are identified separately in the income statement but the effects of changes in real exchange rates on revenues and costs are not.

To overcome these difficulties, companies must ensure that both the operations and the finance divisions understand operating exposure and must define an appropriate sharing of responsibility for its management between the two.

We can separate the effects of exchange rates on operating profits into margin effects and volume effects. We shall illustrate each type of effect with examples based on composites of companies. Economy Motors, a U. Traditionalists would say the company has no exposure to changes in exchange rates. The fact is, however, that its operating profit is exposed to changes in the real yen-dollar exchange rate.

The company competes in the United States with Japanese manufacturers who are the market leaders. When setting a dollar price in the United States, the Japanese companies consider their yen costs. Exhibit II illustrates the competitive position of Economy Motors. The same is true when the dollar costs of Economy Motors in the base year bear their normal relationship—but are not necessarily equal—to the dollar-equivalent costs of its competitors.

If, in a later year, Japan experiences a higher inflation rate than the United States, and if the yen weakens in line with PPP, the competitive position of Economy Motors does not change. If, however, the yen weakens relative to the dollar by an amount more than required by PPP, the dollar-equivalent costs of the Japanese companies will be less than the costs of Economy Motors and the competitive position of Economy Motors will weaken. This was the case between and for many U. The importance of market structure in determining operating exposure is evident in the following two cases:.

This raises a number of questions: Does Specialty Chemicals have a Canadian dollar operating exposure? Should it construct a Canadian manufacturing plant to match revenues and costs? Should the company issue Canadian dollar debt so that if the Canadian dollar weakens, it can reduce the U.

To answer these questions, Specialty Chemicals must examine the structure of the marketplace in which it sells its product. This may make low interest rates seem like bad news. If inflation the rate at which prices are rising gets too high, because demand for goods exceeds supply, it can cause economic instability and currency depreciation.

A central bank may then attempt to counteract inflation by raising interest rates, thus encouraging people to put their money into a savings account rather than spend it on goods. This means that demand drops and inflation slows down. But the converse is also often true: higher interest rates are generally associated with higher exchange rates because investors get a higher return on their assets compared to the same assets in another currency.

Related to all of the above is one overarching factor: stability. The market loves it and is constantly monitoring economic indicators and current events to find where it exists and where it may be lacking.

However, if the country is going through a period of political upheaval, these economic factors pale into insignificance. This discourages foreign investment and often leads to a decrease in demand for the currency and its value drops across the globe: for example, uncertainty over the repercussions of the Brexit vote led to a freefall in the value of sterling.