Exchange rate volatility : an analytical risk model

Abstract

Risk management is an amount topic in the financial sector, following major financial losses from the 1990s onwards. Financial markets are undergoing tremendous change driven by globalisation, advances in technology, mergers and acquisitions and a constantly changing political environment. The resulting competitive and challenging environment makes it imperative that all financial players understand the risks they are facing and have effective analysis and control measures in place to deal with these risks. Exchange rate risk or currency risk is the risk that a business' operations or an investment's value will be affected by changes in exchange rates. By having a better understanding of the factors that determine and influence a country's currency, it becomes possible to foresee potential fluctuations in a currency's external value. A model to predict the exchange rate risk can be invaluable for international corporations in the evaluation and planning of proposed projects. However, many authors maintain that there is no reliable method available to forecast exchange rates or exchange rate risk. Due to the continuing international move towards globalisation, emerging markets of the world, of which SA is one, are ever more dependant on the value of their currencies relative to the currencies of their major trading partners. At present the South African Rand floats against the major world currencies since the partial abolition of exchange rate controls, especially those applicable to non-residents. This makes the Rand more vulnerable to fluctuations in the world economy. The purpose of the study is to develop a model for the analytical assessment of exchange rate risk and volatility for the South African Rand (ZAR) versus the United States Dollar (USD). Fit a literature study is presented which include a discussion on exchange rates, exchange rate risk and the determinants of demand and supply of foreign currencies. Exchange rate prediction and risk models from the literature are briefly explained and evaluated. An overview of the unique factors contributing to exchange rate volatility and risk in the South African economy is provided. The monetary model is used for developing the empirical functions for the prediction of the ZAR I USD exchange rate. Multiple regression analysis is applied in developing the different functions. The analysis indicates that the ZAR / USD exchange rate increases when the SA monetary authorities' discipline is deteriorating in comparisons with its US counterpart. Economic growth, as measured by Gross Domestic Product (GDP), crm lead to an appreciation of the ZAR compared to the USD, should the domestic expansion of GDP exceed that of the US. Rising inflation rates in SA also lead to an increase in the exchange rate due to rising domestic prices. An exchange rate risk model is developed based on fiscal policy stance, opening or closing of trade regimes and levels of foreign currency reserves relative to GDP. These variables are the explanatory forces behind the volatility of South Africa's exchange rate and are labeled exchange rate risk factors. Increases in the M3 money supply and GDP levels have the most pronounced effect on volatility of the ZAR versus USD. While the M3 money supplies present a depreciation risk, an increase in the domestic GDP level present an appreciation risk for the ZAR I USD exchange rate. Openness of the economy as portrayed by the ratio of imports and exports to GDP as well as inflation and national debt levels, presenting a dimension of fiscal policy stance, have a relative large effect on the volatility of the exchange rate. Increases in the domestic levels of all three these variables present depreciation risks. Fluctuations in the domestic foreign reserve level had only a small impact on the exchange rate. The exchange rate prediction and risk models developed can be used in conjunction for forecasting and risk analysis purposes.