"Currency volatility represents the fluctuation in the value of a currency, and it is of particular interest to businesses as it directly impacts international operations."
What is Currency Volatility?
The currency volatility represents the fluctuation in the value of a currency, and it is of particular interest to businesses as it directly impacts international operations. It embodies the risk component in the risk-return equation. When discussing volatility, we generally refer to the magnitude and frequency of market fluctuations.
For businesses operating with the Canadian dollar (CAD) as their functional currency, a commercial transaction worth 1 million CAD carries no foreign exchange risk.
Factors Influencing Currency Volatility
Several factors impact currency volatility [1]. Monetary policy directly impacts currency flows. Central banks use interest rates to control the money supply. Monitoring the decisions of institutions such as the U.S. Federal Reserve, the European Central Bank (ECB), and monetary authorities in Canada and Japan is crucial.
Trade wars are frequent and generate significant volatility. Whether it is the ongoing disputes between China and the U.S., the UK and the EU, or even Canada and the U.S., these conflicts create disturbances in the affected currencies, as billions of transactions are impacted. Geopolitical factors also play a role. Government decisions on issues such as public health (e.g., mass vaccine procurement for COVID-19) or military tensions between Ukraine and Russia have a direct and lasting impact on the associated currencies.
Furthermore, market perception can dramatically influence currency pair volatility. The sentiment of traders and investors can shift rapidly, altering market dynamics. This sentiment is reflected in implied volatility, which is used to price options. In calm market conditions, implied volatility remains low. However, during periods of uncertainty, it increases significantly.
At its core, volatility is directly linked to liquidity. Liquidity refers to the supply and demand present in the market. The greater the liquidity, the harder it is for market participants to impact prices. Consequently, higher liquidity leads to lower volatility and vice versa.
Impact of Volatility on SMEs
For SMEs engaged in international business, currency volatility poses multiple challenges. Large market fluctuations create uncertainty in cash flow management. Ensuring the right amount of the correct currency is available at the right time for client and supplier payments becomes increasingly difficult, making cash flow positions less predictable.[2].
Transaction Management
Higher volatility means that the size of commercial transactions must be carefully considered, as critical tolerance thresholds can be exceeded more quickly. The same applies to spot and forward transactions; spreading market interventions over a longer period and in multiple steps becomes essential.
The currency pairs an SME trades are determined by supplier choices (imports) and the markets it chooses to develop internationally (exports). As a result, assessing the competitive advantage of a foreign supplier must include an evaluation of currency volatility and the associated risk management costs. Ultimately, this directly affects a company’s profitability.
Measuring Currency Volatility
It is possible to calculate historical volatility for a given currency pair to gain insight into its risk level. This involves calculating the standard deviation of exchange rate movements over a past period. The standard deviation measures how widely values disperse around their average.
Since exchange rates frequently deviate from their average value—sometimes significantly due to geopolitical shifts—it becomes challenging to rely on averages alone as a reference. The probability of extreme price movements, both in magnitude and direction, is high.
Implied Volatility
Volatility also impacts option pricing. The price of an option reflects an anticipated level of volatility, known as implied volatility. It is important to note that volatility evolves over time and is not constant.
Since not all currencies behave the same way in the foreign exchange market, some experience higher-impact volatility than others. As a result, a company’s profitability can be significantly influenced depending on the currencies in which transactions are denominated.
In a future article, we will discuss how to integrate these various impacts into the budgeting process.
[1] See: Volatility and Inflation in a Context of Economic Growth [2] See Currency Risk Management – Defining a Cash Flow Strategy
For more insight, read: Currency Volatility: Turbulence Ahead in the Foreign Exchange Market? , Currency Volatility: Understanding the Scope of Exchange Rate Risk. and 5 ways to manage market ups and downs
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