Understanding Currency Volatility and its Causes

Types of Currency Volatility

In the case of the forex market (Foreign Exchange Market), the volatility of currencies is generally classified into three types. These are as follows: 

Historical Volatility

It refers to the estimate of fluctuations based on a period from 10 to 180 days. It is generally calculated by determining the average deviation from the average price of a financial instrument during a specific period. The higher the historical volatility value, the riskier the security becomes. It does not, however, measure the chances of loss but rather measures how far a security’s price deviates from its mean value.

Implied Volatility

Implied volatility is one of the major concepts to understand regarding trading. It refers to the estimation based on expectations of future supply and demand. This indicates how volatile the market can be in the future. Implied volatility also helps one calculate probability. It helps to identify market risks, allowing one to make strategies to overcome potential rate fluctuations.

Intraday Volatility

Intraday volatility is the estimation based on fluctuations between closing and opening market prices. It refers to the variation of prices of stock in a single day. It is important to understand the concept of intraday volatility, as it helps to make decisions based on quick price fluctuations and to effectively identify market risks. Transacting in intraday shares is comparatively low risk, as the securities are purchased on the same day.

Key Causes of Currency Volatility

Exchange rates constantly shift as the demand for a currency goes up or down. Several factors lead to fluctuations in trade market rates. They include:

Inflation: This can be considered a major reason for currency volatility. Inflation happens when the price of goods and services increases resulting in a decrease in the value of the currency. When the perceived value of a currency goes down, this stops investors from buying it. This directly leads to the currency losing its value in the market, making the exchange rates drop drastically.

Recession: Recession refers to the state when a country’s GDP (Gross Domestic Product) and the total value of all goods produced within the country drop. This weakens the economy of a country, triggering high unemployment. Consequently, the currency of the country will lose its value in the market, leading to fewer investments and lower interest rates.

Interest Rates: Interest rates are an integral factor that plays a crucial role in establishing a currency’s value. It is common practice for governments to adjust interest rates to manage inflation and to aid economic growth. This can lead to raising the exchange rates for the country higher. The relationship between exchange rates and interest rates is focused on supply and demand. When interest rates are raised, this makes borrowing and buying harder, thus making the value of currency go up. The opposite effect happens when the rates are lowered.

Stock Markets: Stock markets are another major factor influencing currency volatility. The performance of the stock markets of a country is a good indicator of the country's economic growth and stability. The better the performance, the more value the currency achieves. If the stock market of a nation performs poorly, this can lead to fewer foreign investment, leading to the currency losing its value.

Political Instability: All through history, political instability has always led to the stock markets crashing, leading to economic crises. When a country’s economy is weak owing to political instability, this can lead to the currency losing its value. The chaos and uncertainty caused by political unrest can deter foreign investors from investing. It can also create inflation or hyperinflation, both of which can adversely affect the economy of the country.

How Currency Volatility Affects People

Currency ups and downs impact everyday life in various ways. Here is how they affect people: 

• When the value of the local currency decreases then imported goods become more expensive. This leads to higher prices for everyday items like food, fuel, and clothes. 
• When companies face high costs, they start reducing their staff in order to save money. This results in fewer job opportunities and can slow down the local economy. 
• A weak currency lowers the value of savings and pensions. It also makes it difficult for people to invest or buy property in other countries. 

How Currency Volatility Affects Businesses 

Currency changes affect businesses in different ways. These are as follows: 

• If you sell goods to another country and at that time, there is a change in the exchange rate then you will get less value for your payment. If the currency of the buyer becomes weaker, then you may earn less after converting it. 
• Major currency changes can make trading risky, and because of that, many businesses stop dealing with certain countries. This causes a negative impact on trade relationships and leads to job losses. 
• If you are buying from abroad, you might end up paying more if the exchange rate changes before you pay. This makes it harder to plan costs and manage your budget.