What is volatility
Volatility is the measure of the rapid and unpredictable changes that an entity or thing experiences. It is commonly used in finance to describe how risky an asset is. By definition, it is measured statistically as the distribution of returns of an underlying asset; thus, the more volatile the underlying asset, the riskier it is.
In simpler terms, volatility is really a measure of variance and or uncertainty over a specific time period. While It often used to describe stocks and oil prices, in business, volatility has a far-reaching impact on both the cash flows and operating profits of an organization.
- Volatility is the variance and change that something experiences over a time period e.g. in finance it is the returns
- Volatile currency exchange rates impact a business both in direct financial dollars through contractual agreements and in the operating profit through the competitive position of the business
- Businesses can manage accounting exposure through financial instruments like currency swaps and or futures contracts
- For operational exposure, businesses can engage in different strategies, such as product differentiation or strategically realigning the business unit portfolio to hedge against the risk
Volatile currency exchange rates
Currencies such as the US dollar, Canadian dollar, and British pound are floating exchange rates. Their value compared to another currency changes with supply and demand. The change in value is volatility and is what exposes businesses to currency risk.
When a foreign organization goes to pay for an invoice in USD, they must first exchange monies from their home currency to USD at a rate that is called the nominal exchange rate. It is the relative price between two currencies irrespective of the currency’s buying power.
There is also the real exchange rate, which accounts for the country’s inflation. Differing inflation in countries impacts the ability of individuals and organizations between two countries to purchase the same goods. For example, if inflation drives up the price of a beer in the US from $5.00 to $8.00, and the exchange rate between the US and Canada has not changed, then it will cost more in CAD to buy the same good. In the long run, economic factors will bring the two countries back in line so that a basket of goods will cost relatively the same in each country. This is known as purchasing power parity.
Because the long run can mean up to several years, volatility in the currency exchange rate during that time will impact a business. The change in the real exchange rate, which is the changes in the nominal exchange rate less the difference between the two countries’ inflation rate, is what impacts the business operationally.
How volatile exchange rates impact a business
Volatile currency exchange rates can expose a business to risk from an accounting and operational perspective. From an accounting perspective, volatile exchange rates impact the contractual obligations of a business. These include any of the business’s accounts receivables, accounts payables, and debt.
For example, a US-based business has suppliers in England who issue invoices in British pounds. If the British pound goes up in value, then it costs more for the business to pay the invoice. If the British pound depreciates in value, then it costs less. Account exposure impacts the actual dollars paid and or received by a business.
From an operational perspective, volatile exchange rates impact a business’s operating profit and competitiveness in the market. This can occur even if the business operates and sells in a single country because of potential foreign competitors and purchasing power parity.
For example, a US-based business manufactures and sells widgets exclusively in the US. Their competitor is the market leader and is based out of Canada. As the market leader, the competitor can set widget prices and does so taking into consideration their Canadian costs. If USD and CAD are on par, then the competitive positions between both companies are normal and profit margins are also considered normal.
In the following year, if inflation in Canada goes up by more than the inflation in the US, but the Canadian dollar weakens by more than what is needed for purchasing power parity, then the Canadian company’s costs are less than the US-based business. This makes the US-based business less competitive than the market leader as the Canadian company’s profit margins are higher.
Where a business operates, where it sells, and who its competitors are ultimately impact the profitability of the business. Here in the example, there was no change in the USD nominal exchange rate but rather changes in the real exchange rate between the two countries.
Managing a business’s exposure to volatile exchange rates
Most organizations practise some form of risk management for account exposure through financial instruments such as forwards contracts or simply invoicing in the appropriate currency. Operational hedging is less practiced since its risks are less obvious. Additionally, some organizations may lack clarity on who is responsible for managing operational exposure to currency risk, making it difficult to hold any single leader accountable.
There are different ways to manage the operations of a business to hedge against volatile currency exchange. These include:
Structural hedge – businesses can organize their business in a fashion that creates a structural hedge against currency risk. This can mean manufacturing in countries that they sell in or sourcing raw materials from other countries.
Strategic configuration of a portfolio of businesses – an organization with multiple business units can look at offsetting an operationally exposed business with ones that reduce the impact of the exposure. The idea is to minimize the overall risk to the overarching business.
Product differentiation – creating products that do not compete with market leaders is another way to hedge against operational exposure. By differentiating, the product will no longer compete directly with the market leader, which will allow the business to set the price. This provides the business with a little more control over its operating profit margin.
Optimizing through global reach – global companies that operate in multiple countries can potentially hedge against operational exposure by leveraging their operations in countries with favourable currencies that would allow them to exploit the exchange rate.