How to Calculate Exchange Rate Volatility, Mitigate and Leverage it

Cross-border businesses exist in the space of an interconnected global economy where exchange rate volatility is ever-present. Because it cannot be avoided, it becomes a concern for companies that try to either minimise it or harness it to their advantage.

It was estimated that in the third quarter of 2022, European companies experienced a staggering 68% increase in FX-related headwinds. For CFOs and finance managers of global businesses, navigating exchange rate volatility is not optional; it’s a necessity. While commonly viewed as a risk, exchange rate fluctuations can also present certain strategic opportunities for savvy financial leaders.

In this article, we discuss exchange rate and forex volatility indicators at large, including how to check volatility in forex, and provide tips on minimising risks and taking advantage of the opportunities.

Forex volatility is a phenomenon characterised by rapid and significant changes in currency value pairs. It is influenced by a variety of factors, including the political and economic climate, supply and demand, policies, as well as traders' predictions and behaviours, and it can have a massive impact on a company’s financial health, both in the short and the long term.

There are various factors that drive the volatility in forex — from economic indicators, geopolitical events, policy and regulatory changes, to overall market sentiment. Finance professionals need to stay ahead of the changes and often use a formula to track and quantify the volatility — the standard deviation of percentage changes in exchange rates over a specific period.

Let’s break it down into a working example.

In order to work out the volatility of the GBP/EUR exchange rate over 30 days:

Aggregate the data on daily exchange rates for the past 30 days.

Calculate the daily percentage changes.

Lastly, calculate the standard deviation of these changes.

The result is a numerical representation of the volatility. The higher the number, the higher the instability; the lower the number, the less volatile the currency pair is.

There are also tools available to monitor volatility in forex. The most well-known ones are the Average True Range (ATR) and Bollinger Bands. ATR is an indicator that measures how much the price has changed over a set period by averaging the difference between the high and the low. The higher the ATR, the more volatile the market conditions. Bollinger Bands represent volatility using three bands — the middle band is a simple moving average, while the upper and lower bands are set a certain number of standard deviations away from it. As the bands widen, the volatility increases.

Forex fluctuations impact all cross-border businesses. The more currencies the company trades in, the more it will be affected by the volatile foreign exchange market.

Understanding current market volatility is essential for businesses to navigate the complexities of the forex market and make informed financial decisions.

Firstly, if a business collects revenue in a foreign currency before converting it to their home currency, the foreign income may be inflated or deflated depending on market conditions:If it’s deflated, in the short term, this may affect the business’s ability to meet its short-term liabilities.

In the medium and long term, it will also distort financial reports and statements and complicate planning and forecasting.

A similar principle applies to business expenses. Depending on currency fluctuations, the average price of materials and services may go up or down, making it difficult to maintain consistent profit margins, avoid overspending, and stay on track with budgets. If there are major fluctuations relating to one currency, suppliers may be tempted to raise prices, which in turn makes maintaining consistent and good vendor relationships harder.

Just as suppliers may raise their prices, if the business is selling to customers in various countries and currencies, they may be pushed to readjust their pricing strategies to maintain a competitive edge. This may unfortunately put a strain on customer relationships and reputation.

Apart from trading in various currencies, if a business holds assets in foreign denominations, the value of those funds may increase or decrease. This affects the company’s trading strategy and overall financial position and valuation.

It is an undeniable fact that forex volatility is a risk, and cross-border businesses need to shield themselves from its impact on profitability and potential growth.

For businesses seeking stability, trading in currency pairs with lower volatility can reduce risk and provide more predictable financial outcomes.

The implementation of robust risk management policies is a must. This may mean setting clear exposure limits for each currency pair and establishing decision-making protocols to ensure quick responses to market changes.

Accurate forecasting and scenario planning that involve historical data and economic indicators can help predict and prepare for potential outcomes. If possible, companies should stress-test financial models with various exchange rate scenarios to prepare for different eventualities.

What will help any cross-border business thrive in the face of high volatility though, is financial resilience. This can be achieved through a diversified currency and financial institution portfolio as well as optimised working capital in all currencies to buffer against short-term fluctuations.

While volatility poses risks, it also presents opportunities for strategic financial management. Timing large purchases or sales based around favourable exchange rates can significantly improve profitability. For example, a French-based exporter might capitalise on a temporary weakness of the pound to boost sales in dollar-denominated markets. Similarly, businesses can make investments in foreign assets at discounted rates, which can help long-term growth. There’s also the option for companies to gain a competitive edge by offering more attractive pricing or seizing opportunities for easier market entry when the local currency is weak.

A case in point is Sage Group, a leading UK-based software company that leveraged the post-Brexit depreciation of the pound to price its cloud-based products more competitively in the North American market, resulting in significant sales growth despite strong competition.

In order to navigate the challenges associated with forex volatility, companies can employ several strategies.

Hedging is one of the most popular tools when it comes to managing forex volatility. Natural hedging involves matching currency outflows, like sales, with inflows, like supplies, to reduce overall exposure. There are also financial hedging instruments like forward contracts or options. Forward contracts allow companies to lock in exchange rates, providing certainty for upcoming transactions. Options, on the other hand, allow businesses to exchange currency at a set rate, offering flexibility and downside protection.

Among operational strategies, there’s dynamic pricing, which involves adjusting prices in response to currency fluctuations. The best tactic, however, is the diversification of currencies and financial institutions, as it spreads the risks and reduces dependence on a single currency pair.

Cross-border businesses should also rely on technological solutions to strengthen their strategies. Having access to real-time monitoring systems can alert finance teams to significant rate changes and allow them to take advantage of potential opportunities. Similarly, automated hedging platforms can execute trades based on predetermined rules.

The advancement of technology has made it easier for CFOs and finance managers to keep an eye on and effectively manage volatility. Here are some key tools and technologies worth considering:

Treasury Management Systems (TMS): These centralised platforms consolidate all currencies across all accounts, institutions, and subsidiaries in one place, offering a holistic view of potential forex exposures.

Fintech Solutions: Advanced fintech solutions combine treasury management capabilities with additional tools such as hedging recommendations, forecasting, and reporting. This enables businesses to not only make better-informed decisions but also take advantage of market conditions.

Fyorin is a comprehensive financial operations platform that allows businesses to manage their global cash from one place. With one login, they can get a real-time overview of their cash position across all currencies, institutions, and subsidiaries. Thanks to our network of global financial institutions, they can access 100+ currencies to send, receive, exchange, and hold funds nearly instantly, thus minimising foreign exchange risk and capitalising on market opportunities.

Are you ready to use exchange rate volatility to your advantage? Get in touch with us by emailing sales@fyorin or book a free demo.