Sample Essay on Factors Affecting Exchange Rate Volatility

Exchange Rate Volatility

Exchange rate volatility is the trend for foreign currencies to raise or decrease in value and affect the profits obtained from foreign exchange trades. Volatility refers to the measurement of the amount that these rate and frequency that these change occur. There are many incidents when exchange rate volatility comes into play. This includes business transactions between parties in two different countries and international investments.

Exchange rates play significant roles in a country’s level of trade, which is quite essential in every free market economy in the country. Nevertheless, there are factors that affect exchange rate volatility. Exchange rates are great economic measures that are extremely monitored analyzed and manipulated by governments. They also impact the real return of an investor’s portfolio, growth of certain sectors and profitability of firms and many other economy determinants.

Exchange rate volatility positively correlates with the degree of central bank intervention and real domestic interest rate. Exchange rate volatility affects any purchasing company and its ability to make profits from its dealings. Investors are also affected by volatility while they try to take advantage of foreign markets. For these reasons, it is wise to look at the factors impacting exchange rate volatility and these factors include;

  • Policy variables- Central bank and the government many times attempt to control exchange rate fluctuations by simply regulating the foreign exchange sector. Another policy or regulation focuses on capital flows [in and out]. Central bank intervention is the other common policy applied in regulating exchange rate volatility. The central bank can intervene by acting against any excess demand or supply of domestic currency in the foreign markets.


  • Macro-economic variables- From the many macroeconomic analysis of exchange rate volatility show that countries with relatively large bilateral trade and nations with correlated economic shocks can easily benefit from a common currency. Financial variables such as external debt also affect optimal exchange rate volatility. Financial openness in such circumstance is quite essential and impacts exchange rate instability. Countries with high real openness level may try and decrease exchange rate volatility; however, their increased trade with other countries will make them more vulnerable to global economy tremors. In essence, they may manifest high exchange rate insecurities.
  • Interest rates- a rise in interest rates would also increase the value of the currency of a country with respect to other currencies used in dealings.
  • Inflation- inflation is the other common factor that impacts exchange rate insecurities. Evidently, higher inflation will lower the currency value depending on the currencies being used for trade.
  • Current account deficit- Current account deficit is usually a measure of a country’s trade in which the value of products it imports exceed the value of commodities in exports. Unfortunately, when the current account deficit is high, the country’s currency value is most likely to reduce or lower in value.

There are different ways on how to evade exchange rate volatility. Nevertheless, most of these methods have their shortcomings. In many foreign business trades, one country can immediately convert its currency to foreign currency to precede any possibility of exchange rate volatility. Through, futures contracts, it is easy to prevent volatility by locking in exchange rates. However, this action may also prevent one party in the trade from benefiting if the rates are transferred to their advantage.

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