Exchange rate volatility refers to the tendency of foreign currencies to appreciate or depreciate, which affects the profitability of foreign exchange transactions. Volatility is a measure of how much these rates change and the frequency of those changes. There are many circumstances where exchange rate volatility comes into play, including business transactions between parties in two different countries and international investments. While this volatility is difficult to avoid in such circumstances, the use of futures to fix exchange rates can mitigate the effects of price changes.
Volatility can occur in any security that increases or decreases in value. The term is most often used in conjunction with the stock market, but foreign currencies can also be volatile. When exchange rates are floating exchange rates, as opposed to fixed exchange rates, they are likely to rise and fall in value depending on the strength of the economies involved. As a result, exchange rate volatility is something that affects any venture involving two different countries.
To see an example of currency volatility in action, imagine that a company in one country decides to make a purchase from a supplier in another country. They agree on a price even if the actual business transaction does not take place for another six months. In the six months that pass, the currency of the provider's country appreciates significantly. When the purchasing company converts its own currency into foreign currency to acquire the amount specified in the contract, it will have to spend more money to do so.
In this example, exchange rate volatility affected the buying company and perhaps its ability to profit from the purchased supplies. But that volatility can also weigh on investors trying to exploit foreign markets. A US investor who puts his money in a foreign market to take advantage of favorable interest rates in the other country could lose out if the foreign currency depreciates or the US currency appreciates during the term of the investment.
There are ways to protect against exchange rate volatility, but most of these methods have their drawbacks. In foreign trade transactions, one party could immediately convert its money into foreign currency to precede any possible rate volatility. But that would tie up that money and prevent it from being used for domestic opportunities. Futures contracts that fix exchange rates can prevent volatility, but this would also prevent a part of the contract from benefiting if rates move in their favor.