Question

Explain how interest rates, inflation, and market psychology affect foreign exchange. How can organizations protect themselves from foreign exchange volatility. Apply to any currency of your choice. When referring to interest rate, please differentiate real interest rates from nominal interest rates, short-term vs. long-term effect.

Answer 1

Value of currency of a country is converted to currency value of other country;this can be called as foreign exchange.When people of a country wants to invest,lend money to other country,then that investment is changed or converted into the currency of that country in which people or investors are willing to invest.Factors like interest rates,inflation and market psychology affect foreign exchange and foreign investment.It is clearly described below,how these factors affect foreign exchange:

• Real interest rates and nominal interest rate affect foreign exchange.If real interest rates of a country are raised, then the currency value of that country is accelerated.For instance,if Europe's real interest rates are raised, then people of other countries tend to invest in Europe, as they would get higher amount in return.Usually real interest rates boosts the foreign exchange and foreign investment.These real interest rates have a greater impact on short term than in long term.In short term,if real interest rates are raised then the higher amount of foreign investment will be witnessed.This higher amount cannot be witnessed in long term.Nominal interest rates tend to increase the inflation rate.So it is clear that inflation is directly proportional to nominal interest rate.If nominal interest rate fall down,then no inflation can be witnessed.But if nominal interest rates rise,higher inflation can be witnessed.Inflation increases the value of currency and value of interest rates and offers maximum returns on investments.So,if Europe's nominal interest rates has been raised,then value of goods and services,loans,shares,etc will be raised automatically.This attracts foreign investments.This impact is not short term but can be considered as long term as it takes more time for inflation to rise up and settle down .Therefore,both real and nominal interest rates effect foreign exchange.
• Market psychology has a greater impact on foreign exchange.Any investor looks up to invest in that country which has high currency value,reputed share market,etc.Usually,foreign investors have a great knowledge and information regarding the market activities,situation which take place in other countries.They even have knowledge about currencies of various countries and then they invest in that country which has highest currency value.These foreign investors tend to judge other countries by the situations which occurred there.If any major misappropriation,fraud or scam regarding bank issues,share market,cash has taken place in other country, then foreign investors might lose trust and may not invest in that particular country.This impact on the country in which fraud has taken place,is long term as trust cannot be gained overnight.It takes long time for the country to gain trust and reputation inorder to attract investments.

An organisation should be ready to face all the risks.Foreign exchange volatility is the change in exchange rate which occur any time.Usually organisations face difficulty.It should prepare a plan before hand,as the foreign exchange volatility occurs suddenly.For example,let us assume that Japan has branches for its domestic companies in India.If India's currency value has crossed the value of Japan currency,then the headquarters of that organisation which is situated in Japan should take necessary steps to relocate its branch from India to some other country which has low currency value inorder to decrease losses.In case of investments,if any organisation in Japan has foreign investments from India,then organisation should be able to pay the returns to India even if currency of India has increased.These organisations should use its profits or surplus which is gained in previous years to pay the returns of those countries whose currency value has increased.In this manner organisation should protected from foreign exchange volatility.

Hence,this is how foreign exchange is affected due to interest rates,inflation and market psychology.Few factors have short term impact,while other factors have long term impact on the country's economy and on currency value.