Financial managers of multinational companies constantly monitor exchange rates, because cash flows are highly dependent on exchange rates.
When economic conditions change, exchange rates can fluctuate significantly and negatively affect a company’s value. Here we will look at some of the factors that affect exchange rates.
The first factor is the level of inflation. Changes in inflation rates can affect international trade, which in turn affects supply and demand for currencies and therefore affects exchange rates.
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For example, higher inflation in the UK than in other countries tends to devalue the pound sterling as prices for goods and services in the UK rise relatively rapidly. These goods and services then appear more expensive in the eyes of foreigners, which reduces the demand for British exports. Therefore, there will be less demand for Pound Sterling. In addition, British consumers will find European imports more attractive. Therefore, the euro and the euro will provide pounds to buy imports. This increase in the pound supply reduces the value of Sterling.
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The second factor is interest rates. Changes in relative interest rates affect investment in foreign securities, which in turn affects supply and demand for currencies and therefore affects exchange rates. Investors will invest in a place with the highest return for a certain level of risk. Thus, when there is a difference in interest rates between countries with equal debt risk, investors are more likely to lend to a country that offers a higher interest rate. To invest or lend to another country, you must first obtain the currency of that country. This increases the demand for the currency of that nation and increases its value.
The third factor affecting exchange rates is relative income levels. As income can affect the amount of imports required, it can also affect exchange rates. Assume that the income level of the United States rises significantly, while the income level of Britain remains unchanged. In this scenario, the demand for pounds will increase, reflecting the increase in US income and therefore the growing demand for British goods. Second, the pound offer for sale is not expected to change. Therefore, the pound is expected to rise.
The fourth factor affecting exchange rates is government control. Foreign governments can influence the equilibrium exchange rate in many ways, including:
(1) put currency barriers,
(2) put barriers to foreign trade,
(3) interference in foreign exchange markets (currency buying and selling) and
(4) affects macro variables such as inflation, interest rates and income levels.
Other important factors are political and economic. Most investors are wary of risk. They will invest their money where there is a certain certainty. They tend to be reluctant to invest in countries characterized by instability and / or economic stagnation. Instead, they will invest in stable countries that show strong economic growth. A nation with a stable government and economy will attract the most investment. This, in turn, creates a demand for the currency of that nation and increases the value of its currency.