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An exchange rate is the rate at which one currency is exchanged for another currency. Essentially, it’s the price at which money moves between countries, also known as foreign exchange.
As you may already know, a currency is exchanged through the foreign exchange (forex) market.
Below, we discuss some of the most important factors that influence exchange rates and how this can impact your forex trading.
What is the Foreign Exchange Market?
The forex market is extremely complex. It is a financial market that has virtually exploded since the invention of the World Wide Web, making it available to individual traders on a scale unimaginable in its early days.
Its reputation as the biggest, most volatile, most liquid financial market is comparable to none. The forex market experiences a daily trading volume of around $7.5 trillion. The stock market only experiences a $200 billion daily trading volume, which isn’t even 3% of the forex market’s activity.
It’s no secret that the US dollar, euro, and dinar are among the highest currencies in the world, apart from being the most traded. But have you ever wondered who decides what the exchange rates are? Or who dictates the price of a currency? Or what the factors affecting exchange rates are?
What are Exchange Rates
An exchange rate is the value of a country’s currency when it is traded for another currency.
The currency value of one country is relatively stronger or weaker than what it is being traded for. An exchange rate is viewed depending on the relationship between the domestic currency and the exchange currency, or the balance of trade.
In this article, we discuss the many factors that affect exchange rates and how they affect each other.
Fundamental Economic Factors
Fundamentals are a broad group of things that happen in the world that affect a country and the value of its currency being traded to other countries. Most of the time, when people talk about the “fundamentals” of a currency, they’re referring to the economic fundamentals.
Economic fundamentals are based on various aspects such as economic data reports, interest rate levels, monetary policy, international trade flows, and international investment flows, which are all factors affecting exchange rate.
Economic data reports are the most significant information because policy makers and market participants use them to gauge the state of the economy, set monetary policy, and make investment decisions.
From a forex trader’s point of view, data reports stir up markets that influence exchange rates.
Interest Rates
Interest rates are one structural factor that influences exchange rates. They refer to the steady increase in the prices of goods and services.
Interest rates matter to foreign exchange because they directly affect exchange rates. A currency’s interest rate is probably the biggest factor in determining the perceived value of a currency.
Currencies with higher interest rates often attract investors who buy them and fund them with currencies with lower interest rates.
Inflation rates
Meanwhile, inflation rates often impact the value of a country’s currency. However, it is more likely to impact the exchange rate of a country negatively.
An extremely high inflation rate will negatively reflect the domestic currency relative to other countries. Meanwhile, a low inflation rate may mean a stronger currency, however, it is not always favorable to foreign investors.
Take, for example, the Swiss National Bank (SNB). The SNB controls the local currency of Switzerland to keep inflation in check. The SNB often has to decrease its currency value so that foreign investors won’t be discouraged and local investors can maintain business in the country.
Economic performance
A country’s economic performance can be measured through indicators of growth and overall economic activity, such as the gross domestic product (GDP) reports.
These reports tell us where the economy is expanding or contracting and how fast. They can also predict interest rates and give traders an idea of a country’s currency exchange rates.
Monetary Policy
Monetary policy is the set of actions implemented by a country’s central banks. Central banks usually create these policies based on the country’s economic objectives, such as maximum employment, increased GDP, or increased foreign investors.
These affect the domestic currency because central banks are concerned about maintaining or improving price stability and promoting sustainable economic growth.
International Trade
The balance of trade between nations can highly impact a country’s exchange rates.
A country that has goods and services that are in high demand internationally will typically see an increase in the value of its currency.
On the other hand, countries with large trade deficits or countries that purchase more exported goods than they import them tend to see currency exchange rates devalue. This is because most of their currency is used to purchase the currency of other nations to pay for exported goods.
International Investment Flows
International investment flows consider cross-border transactions for direct investments.
Capital inflows from foreign investors can lead to currency appreciation, shifting supply and demand for the currency. Meanwhile, capital outflows can result in currency depreciation due to reduced demand.
Political & Geopolitical Fundamentals
Like the country’s economy, political and geopolitical events also directly affect the exchange rates. Suppose political events, such as an election, a war, or a scandal, are seen to be impacting confidence in a nation’s leadership. In that case, the value of the country’s exchange rates will be negatively affected.
Forex traders are always looking at the overall outlook for a country’s perceived currency value. Therefore, they are constantly monitoring political news and events to anticipate changes in policies and economic performance reports from countries.
Elections are another political event that affects foreign exchange rates, as they could mean a change in economic policies.
Technical Factors
Technical factors that influence exchange rates refer to data that can be found through technical analysis. This involves chart analysis, trend-line analysis, and statistical studies of price behavior.
These factors sometimes have nothing to do with a country, but rather the price patterns formed throughout its history.
A rise in the price to its peak every five years, for example, could tell you that it will reach another peak in the next five years. However, much like any analysis, it is best to combine this with other forms of market analysis.
Market Dynamics
Aside from understanding the fundamental economic and technical factors, the behavior of the market, or market dynamics, also greatly impacts exchange rates.
Market dynamics play an important role in determining the exchange rate. It is affected by supply and demand, interest rates, and all the other factors mentioned above.
In terms of trade, the difference between market dynamics and economic fundamentals is that market dynamics is often a market’s reaction to the current economic performance.
Gathering and analyzing all this information is a regular part of a forex trader’s daily routine. The ability to determine how these factors affect the exchange rate is a top attribute for successful traders.