Determinants Of Foreign Exchange Rates

A country’s foreign exchange rates are an indication of its economic health. Its exchange rate plays a very important role in its trade level. It is for this reason that rates are constantly scrutinized, analyzed and at times manipulated by government departments. For the individual investor, these rates often have an adverse effect on their portfolios.

Trading activities between countries is the main factor that affects currency rate fluctuations. When a country shows an increase in its currency rate, its export prices will increase, and its import prices will drop in the foreign market. The reverse is true when a country has a low currency rate. If a country has a low exchange rate, its trade balance will increase, but a high exchange rate will decrease its trade balance.

Current Account Deficit

The trade difference between a country and its trade partners is termed as a ‘current account.’ It shows the difference between payments made from one country to another for interest, dividends, goods and services. A deficit in a country’s current account shows that it is spending more on foreign trade than it is earning from other countries. It is also indicative of the fact that a country requires funding from foreign sources to get rid of its deficit. This indicates that a country requires more foreign currency than it is earning from its exports. This means that the demand for its products is not very high.

Interest Rates

The correlation between inflation, interest rates and foreign exchange rates is extremely strong. If central banks make the decision to manipulate interest rates, there is a direct influence on inflation and the currency exchange rate. By raising the interest rate, lenders achieve a higher return than in other countries. This attracts investment from foreign countries which causes an increase in the exchange rate. When interest rates are brought down, the return for lenders decreases which brings down the exchange rate.

Inflation

If a country has a consistently low inflation rate, its currency value will increase. This is so because the country’s purchasing power increases in relation to foreign currencies. The countries who maintained low inflation rates during the past fifty or so years are Germany, Japan and Switzerland. Low inflation in North America was only achieved much later. Countries that have a high inflation rate experience a dip in their currency rate as opposed to their trade partners. This phenomenon is linked to high interest rates.

The foreign currency exchange rates linked to your investments will be the determining factor of the actual value of your investment portfolio. There are a huge number of factors that determine a country’s exchange rate and these are complicated enough to leave many experienced traders confused. If you are an avid investor or foreign currency trader, you should become familiar with concepts that determine currency values. These rates will have a dramatic effect on the return on your investments.

Foreign currency exchange rates are determined by several factors and this not only affects trading between countries, it also affects the individual consumer in several ways. Corporations who trade with other countries are also affected negatively at times.

 

AN INTRODUCTION TO FOREIGN EXCHANGE RATE

Cost of Money

Modern economies are dependent upon their national currency. It allows the determination of the value of goods across all countries. The foreign exchange rate can be termed as the cost of one currency compared to another currency. For example if you require US dollars and you have British pounds, you can exchange one British pound for $1.52.

The History of U.S. Foreign Exchange Rates

All the world currencies used to be determined by gold reserves. It meant that any paper money issued by a government had to be equivalent to the same amount of gold held in reserve by that government. During the 1930s, the United States set the dollar’s value at a level of $35 to an ounce of gold. After the Second World War, other countries started basing their currency’s value on the US dollar. Since the U.S. had a set value to their dollar, it was simple for other currencies to use the same calculation.

The U.S. inflation rate increased, lowering the value of its currency. This made other currencies more valuable compared to the dollar and the US had to make a decision regarding their currency’s value. It was then determined that the value of the dollar would be reduced and the value of an ounce of gold was placed at $70. The U.S. removed the gold standard completely in 1971. This meant that its currency value was determined by market forces only.

Exchange Methods

Governments of different countries make use of two main systems to determine its exchange rate. These are pegged and floating currency exchange rates.

Floating Rate

• A floating exchange rate is determined by market factors. This means that a country’s currency is valued at the rate buyers are prepared to pay for it. The basis for this valuation is supply and demand which has driving forces such as inflation, foreign investment and other economic factors. This is not a perfect system as countries with unstable economies often suffer under the supply and demand economic law.

Pegged Rate

• A pegged rate is a fixed system whereby the rate is set and maintained artificially by a government. This rate generally suffers no fluctuation.

• National banks have to hold huge amounts of foreign currency to ride the waves of supply and demand. In the event that there is a sudden demand for a specific currency, the central bank has to release sufficient currency to meet that demand.

There are many determining factors related to foreign exchange rates. Those who wish to trade in this market should be aware of these factors.