SIMULATION Explain 5 reasons why exchange rates can be volatile Five Reasons Why Exchange Rates Can Be Volatile Introduction Exchange rates are constantly fluctuating due to economic, political, and market forces. Volatility in exchange rates affects global trade, procurement costs, and business profitability. Companies engaged in international supply chains or global expansion must understand the factors that drive currency fluctuations to manage risks effectively. This answer explores five key reasons why exchange rates experience volatility. 1. Interest Rate Differentials 🔹(Monetary Policy Impact) Explanation Central banks set interest rates to control inflation and economic growth. Countries with higher interest rates attract foreign investment, increasing demand for their currency. ✅ How It Causes Volatility? Rising interest rates → Attracts foreign investors → Currency appreciates 🔹 Falling interest rates → Reduces investment appeal → Currency depreciates 🔹 🔹Example: When the US Federal Reserve raises interest rates, the US dollar strengthens as investors move capital to USD-based assets. 🔹Key Takeaway: Exchange rates fluctuate as investors adjust capital flows based on interest rate expectations. 2. Inflation Rates 🔹(Purchasing Power Impact) Explanation Inflation reduces the value of money, leading to lower purchasing power. Countries with high inflation tend to see their currency weaken, while those with low inflation maintain a stronger currency. ✅ How It Causes Volatility? High inflation → Reduces confidence in currency → Depreciation 🔹 Low inflation → Increases currency stability → Appreciation 🔹 🔹Example: The Turkish Lira has depreciated significantly due to high inflation rates, making imports expensive. 🔹Key Takeaway: Inflation affects the real value of money, influencing exchange rate stability. 3. Speculation and Market Sentiment 🔹(Investor Behavior Impact) Explanation Foreign exchange markets (Forex) are driven by investor speculation. Traders buy and sell currencies based on market trends, geopolitical risks, and economic forecasts. ✅ How It Causes Volatility? If investors expect a currency to strengthen, they buy more → Increases demand and value 🔹 If investors lose confidence, they sell off holdings → Causes depreciation 🔹 🔹Example: In 2016, after the Brexit referendum, speculation about the UK economy caused the British pound (GBP) to drop sharply. 🔹Key Takeaway: Investor behavior and speculation create short-term exchange rate volatility. 4. Political Instability & Economic Uncertainty 🔹️ (Government Policies & Geopolitics) Explanation Political uncertainty and economic instability weaken investor confidence, leading to capital flight from riskier currencies. Countries with stable governments and strong economies maintain more stable exchange rates. ✅ How It Causes Volatility? Political crises, elections, or policy changes → Uncertainty → Currency depreciation 🔹 Stable governance and economic reforms → Confidence → Currency appreciation 🔹 🔹Example: Argentina’s peso lost value due to economic instability and high debt. Switzerland’s Swiss Franc (CHF) remains strong due to political stability and its reputation as a "safe- haven" currency. 🔹Key Takeaway: Political and economic uncertainty increase exchange rate volatility by influencing investor confidence. 5. Trade Balances & Current Account Deficits 🔹(Export-Import Impact) Explanation The balance of trade (exports vs. imports) impacts currency demand. Countries that export more than they import experience higher demand for their currency, leading to appreciation. Conversely, nations with large trade deficits see their currencies depreciate. ✅ How It Causes Volatility? Trade surplus (more exports) → Demand for local currency rises → Appreciation 🔹 Trade deficit (more imports) → Increased need for foreign currency → Depreciation 🔹 🔹Example: China’s trade surplus strengthens the Chinese Yuan (CNY). The US dollar fluctuates based on its import-export trade balance. 🔹Key Takeaway: Exchange rates shift as global trade patterns change, affecting currency demand. Conclusion Exchange rate volatility is driven by economic, financial, and political factors: 1️⃣ Interest Rates – Higher rates attract investment, strengthening currency. 2️⃣ Inflation Rates – High inflation erodes value, weakening currency. 3️⃣ Speculation & Market Sentiment – Investor behavior influences short-term fluctuations. 4️⃣ Political & Economic Uncertainty – Instability causes capital flight and depreciation. 5️⃣ Trade Balances & Deficits – Export-driven economies see appreciation, while import-heavy nations experience depreciation. Understanding these drivers helps businesses manage currency risks when engaging in global procurement, contracts, and financial planning.