Question

Please use 500 words explain how speculation in the foreign exchange market could affect the volatility of exchange rates and how will that, in turn, affect an MNC.

Answer 1

Speculation in foreign market involves trying to reap benefit of foreign exchange fluctuation without having any underlying need for the currency (i.e no settlement/ foreign exchange based trade transaction, etc is being covered/hedged). Speculators will either Buy “forwards” and sell “on spot”(when expecting increase) or Buy “On spot” and sell ”forwards” (when expecting decrease) using any derivative instruments such as Options or forwards.

Speculation can have both effects on exchange rate – Stabilizing or destabilizing by increasing volatility of rate. This is because when speculators are trading the contracts, the underlying element is missing & thus the volume in exchange can be higher than normal trade.

Volatility in exchange rate caused by speculation can result in 2 scenarios –

1. Stabilization of rate – The rate of exchange will continue to fluctuate till the time equilibrium is not achieved. This is because after a certain increase/ decrease in rate (caused by speculative bidding), the exchange rate will reflect the underlying valuation (Interest rate, etc). Any further speculative contracts will attract a different class of traders who factoring the real exchange rate, will start taking positions which will counter the speculators position.

2. Destabilization of rate - In case enormous volume of trade by speculators, exchange rate make destabilize in short term. This is because, the when sellers sell the currency when its weak, it increases supply which further reduced the exchange rate thus causing a continuous loop action. The vice versa is also true, though practically limited to upper ceiling. Also, if the rate falls/ rises beyond a critical point, where even the central banks cannot control it via interest rate or open market operations, then it leads to currency destabilization.

However, in most real life cases, while speculation may cause temporary destabilization of rate due to excessive volatility, in longer period of time, the same will lead to stabilization of rate to real exchange rate.

Such volatility can result in extreme scenarios for MNC as they have operations world over. This is primarily due to –

1. If the assets are left unhedged against currency rates fluctuation, the same can lead to disastrous impact in case the exchange rate moves in unfavorable direction, leading to huge losses on MTM of B/s & PnL on reporting

2. If the assets are hedged using derivative, any higher volatility will result in increased cost for hedging, thus reducing the profitability of the operations in that country. This is especially true if the volatility is long term over months/years (probably due to inflated rates by central bank of the economy) which is can make the operations unviable.

In either of above scenarios, it become difficult for the MNC to justify to the shareholders as to why it continue to operate on a miniscule profit compared to risk of overseas operations, unrelatable YoY numbers (due to difference in conversion rates over period), huge gains in a year which may not be sustainable as the currency rate may move to other direction in coming period, difficulty in making solid projections as there is less predictability of exchange rate.

These types of risk will generally make MNCs averse to countries who have a volatile exchange rate.