Foreign Exchange Rate Risk Management: Meaning, Types, Importance and Limitation

In the preceding chapter, we uncovered the complex maze of interest rate parity and the valuation of currency futures, laying bare the brittle relationship between interest rates, exchange rates, and the numerous factors that sway the price valuation of currency futures. We strived to gain more profound knowledge of the Interest Rate Parity and the arbitrage between covered and uncovered transactions, as well as shed light on the functions of market efficiency, which are foundations of foreign market mechanisms. Such inquiry granted us a precious opportunity to understand the principles and practices that must be employed when managing the unstable area of international finance.

Now, when we turn to the new chapter of our journey, we are moving on to Foreign Exchange Rates, which are an important part of the global financial community. This chapter is designed to demystify Fixed and Floating Exchange Rates, offering a detailed explanation of how these regimes work and the determinants of exchange rates in the global market.

The exchange rate of foreign currency is the centrepiece of not only international trade and finance, but the exchange rates serve as the decision-makers regarding transnational transactions and investment deals. The knowledge of how these rates are developed and the systems that determine them is paramount for anybody who is looking to make prudent decisions in the global free market.

With that, let’s now begin our discussion on Foreign Exchange Rates. 

Foreign Exchange Rates 

The foreign exchange rate is central to international finance and world trade as it is a vibrant factor that holds both revenue and incurred expenditure for international trade. The exchange rates influence the amount of currency that is against each other. The impact ranges from a person planning to go on a holiday to multinational corporations undertaking multi-billion dollar transactions.

Think you’re in the process of booking a trip from London to Tokyo. The conversion of British pounds into Japanese yen is dependent on the conditions of the foreign exchange (forex) market. Given the parity rate of 150 yen per pound, £1,000 would give you ¥150,000. These figures vary depending on a large number of factors. Hence, the rate of one time might not be the same as the rate of the next time or even the same as the rate of the previous day.

The (laws of) supply and demand rule the interplay of foreign exchange rates. If the capital of a currency rises above its supply, the currency will remain strong. However, any excess supply over demand will result in the weakening of the currency. As an example, if the UK economy is doing well, then in that case demand for GBP will rise as investors will rush in to obtain UK assets, thereby strengthening GBP vis-a-vis other currencies.

Take a car manufacturing company in Britain that is exporting vehicles to the United States, for example. When the exchange rate between the currency of a car’s home country and the one a car is being sold in is £1 to $1.30, a vehicle that costs £20,000 in the UK market might sell for $26,000 in the US market. Nevertheless, such a fluctuation of £1 to $1.40 in the pound implies that the same car would now be liable for $28,000 in the US. This might change its competitiveness through the higher price in dollars.

Taking into account the foundations and effects of foreign exchange, let's continue with the way a Fixed Exchange Rate Regime works, which is where the value of a currency gets connected to that of another currency, an assemblage of currencies, or a tangible standard like gold.

Fixed Exchange Rate Regime

A fixed Exchange Rate Regime deals with a financial situation where a given country has the value of its currency pegged or fixed to another main currency like the dollar, a basket of currencies, or a hard asset like gold. By doing this, a regime can help a country's currency retain its value within a not-very-wide mark against the standard or currency that was chosen.

How Does Fixed Exchange Rate Regime Work?

Let's imagine a situation where the fictional country of Rivendell comes up with a currency pegging formula that ties the Rivendell Rupee (RR) to the US dollar (USD) at a ratio of 10 RR to 1 USD, for instance. The central bank of Rivendell accepts USD on one hand and the Rivendellian currency RR on the other at a fixed rate, promising thus stable exchange rates. Such stability of a highly developed currency area can then have beneficial economic effects in the form of attractive conditions for international trade and investments, which is especially important for less developed countries.

Fixed exchange rate institutions were created during the Bretton Wood Conference in 1944, the latter of which has become known as the Bretton Woods system. In fact, it was a system of official exchange rates of currencies, which were tied to the US dollar, which was, in turn, fully convertible into gold at a fixed rate. However, the Bretton Woods system ceased operation after the collapse in the early 1970s, and most of the countries adopted its alternative by operating under the system of floating exchange rates, but some countries still prefer to operate under fixed systems or the system of pegged exchange rates for various reasons.

For example, Denmark and Hong Kong apply pegging systems by holding a currency value that equals the Euro and the US dollar value. These countries achieved stability and apparently economic security in such systems after, in a way, they had to give some marginal nuclear power to monetary policy.

Advantages and Challenges

Advantages of Fixed Exchange Rate Regime:

• Stability: A fixed exchange rate regime promotes the preservation of stability in international prices, so this is a positive aspect for countries whose products or production relies on imports and exports.
• Predictability: Companies and financial operators enjoy the fact that exchange rates are stable and predictable, which stimulates long-term planning and large-scale investments.
• Inflation Control: In the case of fixing exchange rates, countries don't have to create their own policy competencies as they can import anti-inflationary measures from the anchor country.

Challenges of Fixed Exchange Rate Regime:

• Monetary Policy Limitations: Countries lose the ability to adjust the monetary policy instruments such as interest rates and reserve requirements. The central bank must lead the artificial fluctuations in foreign exchange rates, which usually result in neglect of its other macroeconomic functions.
• Speculative Attacks: When markets assume the fixed rate is not viable in the long run, they may be involved in speculative attacks by changing the official currency or converting it into other currencies, thus forcing the country to devalue its currency.
• Foreign Reserve Requirements: Holding the fixed exchange rate will call for the enormous volume of foreign currency that replaces the local currency. This can lead to a severe financial problem that is to the country that can back up the government to strongly borrow in order to support.

Floating Exchange Rate System

The Floating Exchange Rate System represents a stark contrast to the fixed regime, characterised by its dynamic nature where the value of a currency is determined by the free market, governed by the forces of supply and demand. Under this system, a currency's price fluctuates freely against others, with minimal intervention from the country's central bank.

The mechanics of the floating system

In a floating exchange rate system, the price at which one currency can be exchanged for another varies continuously. These fluctuations reflect changes in the economic fundamentals, such as inflation rates, interest rates, current-account deficits, and political stability, among other factors. For instance, if the economy of the fictional country of Eldoria is booming, demand for the Eldorian Elites (EE) might increase as investors seek to buy assets in Eldoria, leading to an appreciation of the EE.

Advantages of the floating exchange rate system

• Flexibility and Natural Adjustment: A floating exchange rate regime allows a country's currency to adjust naturally to economic shocks. This flexibility can help a country recover more quickly from a financial downturn.
• Monetary Policy Autonomy: Contrary to the fixed regime, floating rates allow countries to have much more control over their monetary policies. Countries can adjust their interest rates according to variables such as economic conditions without needing to worry at all about maintaining a currency peg.
• Avoidance of Currency Crises: The floating system adjusts currency value automatically, making it less prone to speculative attacks, therefore reducing the likelihood of currency crises.

Challenges and considerations of floating exchange rate system 

While the floating exchange rate system offers significant advantages, it is not without its challenges. These include:

• Fluctuation: It is apparent that having exchange rates determined by free market forces can result in considerable instability in the short run. Undoubtedly, this volatility may be quite troublesome for investors and businesses that want stability for planning and investing purposes.
• Effects on Commerce and Capital Investment: Unexpected shifts in exchange rates can impact the competitiveness of a country's exports and make foreign direct investment more uncertain.

The major economies of the United States, Eurozone, and Japan use a floating exchange rate regime. These economies benefit from the adaptability this provides, enabling them to calibrate monetary policy according to their economic goals without having to sustain a fixed currency value.

Factors Affecting Exchange Rate

The value of a currency in the global market is influenced by a myriad of factors, reflecting the complex interplay of economic, political, and market dynamics. Understanding these factors is crucial for anyone engaged in international finance, as they shape the landscape of global trade and investment.

Economic indicators

• Inflation Rates: Generally, countries with lower inflation rates see an appreciation in the value of their currency in comparison to the currencies of their trading partners. Lower inflation rates are often a sign of a healthy economy, which attracts foreign investors.
• Interest Rates: Changes in interest rates affect currency value and exchange rate. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise.
• Current Account Balances: The current account shows the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest, and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and it needs to borrow capital from foreign sources to make up the deficit, which can devalue its currency.

Political stability and economic performance

Foreign investors inevitably seek out stable countries with strong economic performance. A country with attributes of political stability, effective governance, and robust economic policies will attract investment funds away from countries perceived to have more political and economic risk, thus strengthening its currency.

Market Sentiment

Traders’ perceptions of what a currency should be worth can influence a currency's value in relation to another. News reports, economic indicators, and financial analysis can affect the market sentiment, prompting buying or selling actions that will affect a currency's exchange rate.

Speculation

If traders believe that a currency will strengthen in the future, they are likely to buy more of that currency now. The increased demand will cause the exchange rate to rise. Conversely, if traders expect a currency to weaken, they may sell off their holdings before the value diminishes, leading to a decrease in the exchange rate.

How To Trade Currency Pairs on Angel One?

1. Open the Watchlist and go to the Search tab.
2. Type the Currency pair that you want to trade, e.g. USD-INR. Choose the expiry date which you want to check.
3. Thereafter, you can open the option chain of the particular currency pair and expiry.
4. Choose the contract which you want to trade and click on ‘BUY’ or ‘SELL’.
5. Enter the quantity and order type, e.g. Carryforward, to enter a position.

As we conclude this chapter, it's clear that the world of foreign exchange is a mirror reflecting the ebb and flow of global economic tides. For businesses, investors, and policymakers, understanding these concepts is not just academic; it's a practical necessity for navigating the challenges and opportunities presented by global finance. Armed with this knowledge, we are better equipped to make informed decisions in the international financial arena, where currency values fluctuate in response to an ever-changing mosaic of factors.