Exchange rate volatility refers to the tendency for foreign currencies to appreciate or depreciate in value, thus affecting the profitability of foreign exchange trades. The volatility is the measurement of the amount that these rates change and the frequency of those changes. There are many circumstances when exchange rate volatility comes into play, including business dealings between parties in two different countries and international investments. Although this volatility is difficult to avoid in such circumstances, the use of futures to lock in exchange rates can mitigate the effects of price change.
Volatility can occur in any security that rises or falls in value. The term is most often used in conjunction with the stock market, but foreign currencies can be volatile as well. When exchange rates are floating exchange rates, as opposed to fixed exchange rates, they are likely to go up and down in value depending upon the strength of the economies involved. As a result, volatility is something that affects any business undertaking involving two different countries.
For an example of exchange rate volatility in action, imagine that a business in one country decides to make a purchase from a supplier in another country. They agree on a price, even though the actual business transaction won't occur for another six months. In the six months that pass, the currency of the supplier's country appreciates in value significantly. When the purchasing company coverts its own currency into the foreign currency to acquire the amount specified in the contract, it will have to spend more of its more money to do so.
In that example, volatility of the exchange rate affected the purchasing company and perhaps its ability to make a profit with the supplies it purchased. But such volatility may also affect investors trying to take advantage of foreign markets. An American investor putting his money into a foreign market to take advantage of favorable interest rates in the other country could lose out if either the foreign currency depreciates or American currency appreciates during the term of the investment.
There are ways to hedge against exchange rate volatility, but most of these methods have their drawbacks. In foreign business dealings, one party could immediately covert its money to the foreign currency to predate any possible rate volatility. But that would tie up that money and prevent it from being used for domestic opportunities. Futures contracts that lock in exchange rates can prevent volatility, but that would also prevent one of the parties in the contract from benefiting if the rates moved to their advantage.