Changes in foreign exchange rates The changes in foreign exchange rates arise out of the forces of demand and supply. When demand is high, prices of currencies will rise. However, a rise in the price leads to fall of demand eventually. Similarly, when prices increase, supply of currencies stays high; as more people will be willing to sell off their currencies at higher prices (Mange, 2000). Currency valuations are done on the basis of flow of currency in and out of a country. The value of a currency generally increases due to its high demand.
Demand for currencies is created through factors such as, mergers and acquisitions, international trade and speculations (Albuquerque, 2007). For instance, suppose a company in the US purchases goods from a company in Japan. So, the US company will have to convert its dollars into Japanese yen in order to pay for the goods. The conversion or flow of dollars into yen would imply an increased demand for Japanese yen. If such a flow leads to rise in demand for yen, then net value of yen would subsequently rise (Cummins, Phillips and Smith, 2001). International risks in foreign exchange rates A business may be exposed to the risk of suffering losses due to fluctuations in the foreign exchange rates.
Suppose a US firm makes an investment with another one situated in Europe. So, US dollars will be converted into European pound so as to make such an investment. If the rate of exchange of European pound augments in comparison with US dollars, then while redeeming the investment, the US firm will receive a lower amount due to changes in the exchange rate.
Such types of risks not only affect firms, but also those individuals who make international investments (Battermann, Broll and Wong, 2006). Evaluation of the risks Managing and measuring exchange rate risks are important for a firm as this leads to significant impacts on profits and value of assets. Every firm that indulges in international trade needs to manage such risks by way of developing suitable hedging strategies and analysing the current risk exposures (Bodnar, Jong and Macrae, 2003). The major types of risks faced by most multinational firms in this context are described as follows: Transaction risk- This type of risk arises when there is fluctuation in the exchange rates and transactions which were earlier done at a particular exchange rate gets eventually settled at a different rate (Bowden and Zhu, 2006).
Translation risk- This type of risk arises out of the conversion of foreign currency balances for the purpose of preparing accounts.
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