Question

Discuss the main factors that explain exchange rates and briefly examine how exchange rate volatility can impact MNCs.

Answer 1

Main factors that explain the exchange rates are:

1. Inflation: A low inflation will increase the currency value and the purchasing power increases relative to other countries. Also higher inflation leads to depreciation in currency.

2. Interest rates: An increase in interest rates will attract foreign capital and cause the country's currency to appreciate. While the reduction in interest rates will depreciate the currency.

3. Monetary: A sound economic and monetary policy will increase the value of the currency and a weak one will depreciate the currency.

4. Government controls: Stringent government controls will put away foreign inflows and thereby reduce the currency value while the opposite is true as well.

5. Income level: A country with higher income levels will have more disposable income and thereby the currency value is higher.

6. Expectations of future exchange rates: An anticipated in increase in interest rates will cause an appreciation in the home currency and vice versa.

Exchange rate volatility can impact MNC;s in terms :

1. Exchange rate risk: Exchange rate risk is the depreciation or appreciation of a currency which will result in additional liability to the party which has to pay.

2. Interest rate risk: Interest rate risk affects the currency risk due to changes in interest in the home or foreign country. The currency may be overvalued or undervalued due to interest rate differences.

3. Economic risks: Global economic events have an impact on the exchange rate risk such as tariffs, taxes and government policies.

4. Inflation risk: The increase in general inflation also affects the currency translation.