Currency Fluctuations: Decline in Exchange Rate

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Introduction

Investing in international markets involves encounter with various challenges such as sudden changes in market value. Basically the changes in foreign currency exchange rates affect all international investments.

Nature of risks differs based on the kind of investment and the conditions within the market. It is important for individuals to learn about the political, economic and social conditions of foreign markets before investing. This enables better understanding of the factors affecting financial outcomes and stock prices (Krugman and Obstfeld, 2011).

Some of the potential risks and gains of pricing goods in United States Dollar when selling in an international market

Investors face different potential challenges when operating in the global markets. Most of the challenges are associated with changes in exchange rates. The changes nature of fluctuations experienced with exchange rate impacts return on investment either negatively or positively.

International prices of goods are majorly based on US dollar since it is one of the strongest currencies preferred for international trade. Most of the transactions are done in United States dollars then later converted to local currency of the trading country. Significant increase on return on investment is usually experienced in times when foreign currency strengthens against the US dollar; this is since more dollars are realized when converted into foreign currency.

In times when foreign currency weakens against the dollar low return on investment is recorded since the conversion results into less dollars. At some point some countries usually impose controls in the foreign currency hence restricting the movement of the specified currency out of the country of origin (Krugman and Obstfeld, 2011).

The other risk involves the dramatic changes in market value of foreign markets. Individual investors have experienced loss of money in the process of trying to invest based on U.S. market. This is since timing the U.S. market leaves one with the decision of when to leave or get back based on either fall or rise in prices.

The benefits of trading in U.S. dollars provides the opportunity to growth since it assures one of reducing the risk of losing money in case of abrupt change in the strength of the local currency. It also enables the company trading to expose their investments to both domestic and foreign stocks enabling smooth ride in the overall returns (Krugman and Obstfeld, 2011).

Explanation on Interest rate Parity theory and how it is used to predict future exchange rates

This is a financial theory created based on the fact that the difference between two countries’ interest rates equals to the difference between their forward exchange rates and their spot exchange rates. Forward exchange rate could be referred to as a form of future trading whereby an investor accepts to exchange a currency at specified rate and specified future date.

Spot exchange rate on the other hand refers to the present conversion rates utilized by investors while converting their returns into money. The interest rate parity theory infers that buying currency in the capacity of a spot exchange rate, then transferring the investment to foreign country offering different interest rate results into same amount based on conditions of the forward exchange rate (Levich, 2001).

Interest rate parity works since its absence leads to presence of small investment opportunities. This is considered to exist as a result of the differences between interest rates and exchange rates. Recovery on the equilibrium of interest rate parity leads to disappearance of arbitrage investment due increase in demand for currencies or rise in debt.

Calculation on the current Forward Exchange Rate for the United States and Egypt

Forward Exchange Rate = (spot price) × [(1+ foreign interest rate)/ (1 + base interest rate)]^n.

United States 1USD is equivalent to 6.10EGP

Spot Price 6.10EGP = 1 USD

The interest rate in Egypt is 9.25% while that in the United States is 0.25%. The payment is made within one year, hence n=1

Forward Exchange Rate = 6.1(1.0925/1.0025)¹ = 6.65 EGP = 1USD

Hence in one year 6.65 EGP will serve the equivalence of 1USD (Levich, 2001).

Relationship between monetary policy, interest rates and exchange rates

Interest rates and exchange rates can easily be linked through effects of inflation. Expected inflation affects to greater extent nominal interest rates while foreign and domestic inflation affects exchange rates. There is profound relationship between exchange rate and monetary policy regimes. This can be explained through economic logic models where monetary control is done through bank reserves which ultimately lead to the direction of floating exchange rate.

Monetary policy, interest rates and exchange rates relate in such a manner that either of the three may support or undermine the rest within domestic or external markets. Differentials in exchange rate have extensive effect on the operations of monetary policy. This is since monetary policy determines the kind of exchange rate policy used based on the market trends (Krugman and Obstfeld, 2011).

Factors influencing exchange rate fluctuations

Exchange rate is considered as one of the most vital determinant of the health level of any country’s economy. This is since exchange rate performs crucial role in determining nature of trade a country indulges in and at the same time it impacts the level of returns within an investors’ portfolio.

The nature of trading partnership between countries in the international market is determined by kind of exchange rate preferred based on their individual currencies. Differential exhibited in the rate of inflation affects exchange rates. An experience of decreased inflation rates normally is an indication of significant strength experienced in the currency value.

This leads to an increase in the level of purchasing power of the party country relative to other currencies in operation within the international market. However, increase in inflation rates leads to currency depreciation in currency. Interest rates are also considered as potential influencers of inflation rates as well as the value of various currencies within the international market. High interest rates normally attract foreign capital causing rise in the exchange rate (Grimwade, 2000).

Public debt also influences exchange rates since most countries engage in transactions meant for financing projects. Such activities help in stimulating domestic economy which ultimately determines whether the domestic market is suitable for foreign investment. Large amounts of debts influences high inflation rates and this is serviced through payment by cheaper real dollars. The level of default within the currency determines foreigners’ willingness to own securities denominated by such weak currency (Grimwade, 2000).

Conclusion

Decline in exchange rate contributes to low purchasing power obtained from resulting returns. Investors are therefore advised to obtain appropriate knowledge on currency values and exchange rates before investing in any market since the two contributes towards rate of return on foreign investments. The trading relationship between countries is also influenced by economic, social and prevailing political atmosphere within regions.

References

Grimwade, N. (2000). International trade: New patterns of trade, production & Investment. (2nd Ed.). New York, US: Rout ledge.

Krugman, P.R. & Obstfeld, M. (2011). International Economics: Theory and Policy. (9^th Edition). New York, US: Pearson

Levich, R. M. (2001). International Financial Markets. (2^nd Ed.).New York: McGraw-Hill.

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