Factors that affect foreign exchange risk
Risk presents a basis for opportunity. It is the likelihood that losses will result from certain events e.g. market price fluctuations. To any economy, these risks pose a great threat. The following are factors that influence foreign exchange risks;
- Interest rates – A country with higher interest rates compared to its neighbors offers lenders an opportunity to make more returns when they invest in the country. Investors attracted by high-interest rates, they purchase the currency of the country leading to a higher exchange rate for the country.
- Commodity price – In most instances, currency values are inversely associated with commodities. Since investors use it as a safe haven in case of a falling currency value, exchange rates can be affected by patterns in the hard asset, e.g. oil prices (Horcher, K, A., 2011).
- Inflation rates – Currency exchange rates are influenced by market inflation. A country having a low rate of inflation compared to other experiences an increase in its currency value. Consequently, an increase in the price of its goods and services will be at a slower rate. On the other hand, the country with higher inflation experiences currency depression and higher interest rates.
- Government debt – this is national or public debt that a central government owns. Having government debt makes a country less likely to acquire foreign capital thus experience inflation (Horcher, K, A., 2011). If the market anticipates that a country has government debt foreign investors will sell their bonds in the open market. This leads to a decline in its exchange rate value.
The theories of interest rate determination
There are several theories that analyze the determination and nature of interest rate. The main theories include;
Marginal Productivity Theory – states that the capital’s marginal productivity determines the interest rate. Payment of interest is done due to the productive nature of capital that’s also equal to its marginal product. The function of capital is crucial since more volume is produced with it than without. A higher productivity of capital translates to higher interest and vis a vis. However, since every product is jointly produced from every factor, the marginal product of capital is impossible to determine separately.
The Loanable Funds Theory – states that the interest rate of the market is influenced by factors that control demand for and supply of loanable funds. The demand for loanable funds shows the inverse relationship between the interest rate and the number of loanable funds demanded.An increase in the demand for these funds leads to a decrease in interest rate. Government demand for the loanable funds is interest-elastic; the quantity of demanded loanable funds are not affected by the interest rate (Lutz, F. A. 1968). As interest rate increases so do loanable funds supply.
The Keynesian Theory – In this theory, the main determinant of total employment and output levels is the degree of total spending. A higher level of total spending translates to more output by businesses thus more people employed. In a simple economy lacking foreign trade and government sector, output and employment levels would be determined by investment spending and consumption levels (Lutz, F. A. 1968). According to this theory, there’s a positive relationship between consumption spending and disposable income; higher-income earned means more spending.
Determine an appropriate level of risk tolerance
Risk tolerance refers to the level of variability which an investor is ready to tolerate within investment returns. It is significant to determine the business’ and personal risk tolerance level since there are various forms of investments around thus how does the investor determine their tolerable levels. An appropriate risk tolerance level should consider;
Time horizon – prior to investing the time available to have the money in investment should be determined. Provided longer time horizons, the investors are able to recover potential losses and thus in theory tolerable of larger risks (Investopedia Staff, n.d). For instance, if the investor has $26,000 to purchase a beach house in 10 years, this can be invested in higher-risk stocks instead. Why? The reason being they have more time to recover their losses if any and less likely of being compelled to sell out early from their positions.
Bankroll – Investors should determine the amount of cash they can afford to lose. This is a realistic investment tactic since investing what one stands to lose or tolerate being tied up over certain time periods they will stand pressures of selling off due to panic or issues of liquidity in the market. The more money an investor has, the more risk they can take (Investopedia Staff, n.d).
The three main sources of financial risk
- Exposure of a business or organization to fluctuations in prices in the market like commodity prices, exchange rates, and interest rates.
- Financial risks which arise as a result of transaction dealings and actions of other businesses or organizations like competitors, vendors, clients/ customers and counterparties within derivatives of transactions (Horcher, A. K. 2011)
- Financial risks emanating from internally within the organization e.g. organizational failures specifically from their systems, individuals, and processes (Horcher, A. K. 2011).
Three broad alternatives for managing risk
- Do nothing and actively, or passively by default, accept all risks.
- Hedge a portion of exposures by determining which exposures can and should be hedged.
- Hedge all exposures possible (Horcher, A. K. 2011)
Horcher, A. K. (2011) Essentials of Financial Risk Management, John Wiley and Sons Inc. USA
Horcher, K, A., (2011) Essentials of Financial Risk Management. Wiley Publishers.
Investopedia Staff (n.d). Determining Risk And The Risk Pyramid. Investopedia. Retrieved from http://www.investopedia.com/articles/basics/03/050203.asp
Lutz, F. A. (1968) The Theory of Interest. 2nd Edition. A Division of Transaction Publishers. USA&London