Question

What are the risks of floating exchange rates and make a comparison to the risks in the situation of a host country changing its political system and/or a host country changing its economic system. The key is that something has changed and that creates a risk. These areas of business risks do not usually appear with a solely domestic business, but can in an international business. Discuss the impact of these potential risks on an international business and how management must be vigilant.

Answer 1

Floating exchange rate means that the host country’s currency value fluctuates, as a response to the foreign-exchange market. As floating rates automatically adjust to the global influences, hence, they enable the country to dampen the effects of the business cycles and shocks.

The biggest risk that floating rates bring to businesses engaged in international operations is the unpredictability. Floating exchange rates were implemented by many countries to encourage unrestricted multilateral trade.

Floating rates change by small amounts on a day to day basis, unlike fixed rates which change by substantial percentages, over long intervals. But the risk with floating rates is that this day to day fluctuation is not necessarily small, which can lead to low price elasticity, exchange-rates overshooting affecting company’s profitability and share values, and can cause long lags in liquid and physical money dealings.   

These fluctuations can also lead to inelastic short run supplies (for exports) and large hedging attempts by importers and exporters. These eventually affect both material availability and profitability for the international business. Also, techniques like transfer pricing adjustment, swaps and borrowing or lending abroad will be used by companies to optimize risks, which put the business in harm’s reach.

Lastly, since companies will have more exposure to exchange risk, more and more resources have to be channeled to manage exchange risk functions, and to minimize the exchange losses arising from translation, transactions and economic exposures.