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When investing in a foreign country, it is necessary for investors to take into account the risk arising from currency fluctuations. A gain on an investment in foreign assets might be canceled out because of currency fluctuations, or an investor might experience a windfall gain if the currency of the foreign country strengthens. Investors in foreign securities or other assets must consider the likely exchange rate movement with the currency of the target country and weigh the currency risk together with the other risks of investing. Some investors look for gains through buying and selling foreign currency, hoping to profit from short-term currency fluctuations.
The rate of exchange is the price at which one currency may be converted into another. Generally, where there is a floating exchange rate, there is constant movement of the exchange rates because of various economic factors. This movement affects the value of investments made in a foreign currency.
Where there are floating exchange rates, the rate of exchange of a currency will be affected by the supply and demand. The price of the currency might rise if there is a demand for exports from the country, if the interest rate available on instruments denominated in that currency is relatively high or if there is an inflow of investment into the country. The exchange rates also fluctuate on a daily basis as a result of speculation in the currency, when people acquire foreign currency as an investment in the expectation that the exchange rate will rise. This currency speculation accounts for most of the volume of trading on the foreign exchange markets and causes the rates to rise or fall in the short term based on investor sentiment. In the longer term, the underlying economic factors are likely to be the main influence on the rate of exchange.
Exchange rates are sometimes fixed at one rate or change occasionally on an “adjusted peg” system. Other countries might prefer a “managed floating” exchange rate system in which the rates are generally allowed to change with supply and demand for the currency but might also be adjusted sometimes by government intervention. Investors should look into the exchange rate system of the country in which they are investing and examine the likely effect of the rate of exchange on the value of their investment.
An enterprise making a direct investment in a foreign country by setting up business operations is likely to acquire assets using a foreign currency. The value of these assets to the enterprise might change as a result of currency fluctuations, and this could give rise to a large foreign currency exchange gain or loss. The enterprise might protect itself from the consequences of such currency fluctuations by using a derivative instrument such as a forward contract or an option, which will protect, or “hedge,” the currency risk by canceling out most of the effect of the exchange rate movement. The currency risk is then largely eliminated by hedging so the enterprise will not make any sizable foreign currency gains or losses.
The exchange rate speculator, on the other hand, is not concerned with eliminating risk but is taking on the currency exchange rate risk with the intention of making a profit from the transactions. The speculator is more concerned about predicting the short-term currency fluctuations arising from market sentiment on a daily basis rather than studying the economic fundamentals. Most daily trading on the foreign exchange market results from currency speculation, so the short term currency fluctuations are determined by market reactions to events rather than the underlying state of the economy of each country.
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