Factors that Affect the Exchange Rate

This article might be one of the most important to read if you are trading Forex, especially these days as the chatter regarding the price of the Euro and the ECB chairman’s next move are becoming the talk of Forex traders recently. But before we start, we need to begin by stating the obvious; the Exchange Rate is determined between currency pairs. Exchange rates are quoted in terms of how much of a currency you can buy with another currency so, the exchange rate for the pound sterling of $1.65 means that each pound will cost you 1.65 dollars when you buy it.

The exchange rate invariably fluctuates unless a currency is fixed against another. For example some Caribbean countries fix their dollar with the US dollar.

Factors that affect the Exchange Rate might be too many to sum, but the value of a country’s currency is determined by few important ones, and maybe the most important factor is the Interest Rate in that country. The Interest Rate can be tempered by inflation in the country or its political stability. High interest rates attract foreign currencies to that country, improving the demand for the country’s currency, therefore, its’ exchange rate will increase as investors buy more of that currency to be able to purchase investments in the country.

Forex traders try to anticipate interest rate changes as they can significantly affect exchange rates, but they need to be cautious and realistic since market participants sometimes anticipate the change and price it in the price before the announcement of the Interest Rate.

Traders shouldn’t just be attracted to high interest rates, because the benefit of high Interest Rates can be negated by high inflation which reduces the purchasing power of the currency and so reduce real returns or gains that might be accomplished with the increase of the Interest Rate. Some of the highest interest rates can be found in very volatile countries and again, investors need to be sure that their funds remain relatively liquid as many of these countries restrict the outflow of currency.

The health of a country’s current account is also influential. If a country has a balance of payments deficit, then it needs to sell its own currency to buy foreign currency and pay for the extra goods coming into the country. Doing this reduces the exchange rate and eventually leads to a kind of equilibrium after the reduction in the exchange rate because imports became more expensive and so less desirable.

The level of public debt is a big influencer on exchange rates at the moment and has been for the last few years. Many countries have racked up huge debts and have trouble servicing it. This adds to uncertainty over whether a country will default, reducing inward investment as the likelihood of the investor getting his money back decreases. Debt can be serviced domestically but if this is insufficient they need to look at foreign investment, which is the case with the Euro and the ECB Chairman’s next move this month; selling bonds to foreigners, and reducing prices to make them more attractive.

A government can also increase the money supply, simply by printing money, recently seen in the USA as quantitative easing. This can have an adverse effect on the exchange rate as it can increase inflation by making it easier and cheaper to buy goods and services, increasing the demand for those goods and services, and so increasing the cost.

Variances in the terms of a country’s trade can also have an effect. If a country’s exports are in great demand, then its’ currency’s price will increases since the amount of that country’s currency purchased will also increases, further helping the exchange rate to improve and stabilize, which is what happened with the Australian dollar in 2008-2009 when it doubled its’ price. The converse is also true.

Finally, as has been seen last year in Turkey, political stability can influence the exchange rate since worried investors will sell the currency if they think that the political process is breaking down.

Those factors are part of the fundamentals a trader needs to have knowledge of. Before making a trade, he needs to know how many of them have been factored into the price. The ‘sixth sense’ is simply the ability analyze and predict the direction of one or more of these, and so gaining a competitive advantage which will increase the probability of a very successful trader.