Top 5 Factors

That Affect Exchange Rates

Whether you actively trade in the foreign exchange market—or you’re simply planning your next vacation—it’s an advantage to understand exchange rate dynamics. Why?

Currency is a universal medium of exchange.

Everyone who uses money participates in the economy and, by extension, the foreign exchange market because money supply directly affects the price of goods and services. Currency is like any commodity—its value rises and falls in response to the forces of supply and demand. Changes in currency value are reflected in the exchange rate between two currencies. When one gains in value, the other declines.

A currency is just a commodity and the interest rate is the price of that commodity. This makes interest rates the single most influential factor affecting exchange rates. It’s why they are the “weapon of choice” for most central banks.

Central banks set the benchmark interest rate—the cost for financial institutions to borrow money. Any change to the benchmark rate is reflected in the retail interest rate—the price banks charge consumers and businesses for borrowing money.

If inflation is too high and the central bank wants to slow the rate of growth, it can raise the benchmark rate making it more costly for banks to borrow money. Passing this added cost to retail customers leads to an overall reduction in spending. If the central bank wants to expand growth within the economy, lowering interest rates and making capital more affordable usually encourages spending.

Currencies with higher interest rates attract investors seeking a better return on investment. This makes the currency more attractive as a form of investment and contributes to greater overall demand for the currency.

A country’s balance of trade is the total value of its exports, minus the total value of its imports. If this number is positive, the country is said to have a favorable balance of trade. If the difference is negative, the country has a trade gap.

Each international trade transaction requires the exchange of currencies. When a country sells goods for export, the country buying those goods must convert their own currency to the currency of the exporting nation. Therefore, the more goods a country exports, the greater the demand for its currency.

Yet when the exporting nation itself buys goods for import, it must acquire the currency of the country selling the goods. This effectively increases the supply of the exporting nation’s currency on the forex market. However, if exports exceed imports (i.e. a positive balance of trade), there is typically a positive demand for the exporting nation’s currency.

Investors who seek to diversify their portfolios beyond traditional assets like equities and fixed income investments can invest directly in the foreign exchange, or forex, market. At $4 trillion a day in turnover—$1.5 trillion of which is conducted in the form of “spot” trades—the forex market is many times larger than equity and fixed income markets combined.

Despite the tremendous liquidity in the forex market, historically, only large investment firms and their high-value clients could afford to trade in this massive over-the-counter market. But with the advent of the internet and the online forex dealer, forex trading has opened up to smaller, independent investors.

Greater acceptance of forex as an investible asset class has increased demand for those currencies expected to return the best results. Long-term traders following a “buy and hold” strategy look for currencies offering the best potential as a “store of value” and might be following a carry trade or hedging strategy. Intra-day traders, who typically hold positions for a few hours or a few minutes, attempt to identify more volatile currencies to profit on exchange rate fluctuations.

Like any form of investing, forex trading involves risk. You can potentially reduce this risk by testing your strategies on practice accounts and by educating yourself about the state of global markets, but you can never eliminate entirely the risk that comes with forex trading.

Investors have two key concerns—potential for return and safety of funds. When foreign investors determine that a particular country meets these objectives, demand for assets denominated in that currency rise. Central banks are especially active in dealing in foreign currencies; China and Russia alone hold well over a trillion U.S. dollars in their foreign currency reserves.

To manage risk during times of uncertainty, investors have long sought the perceived safety of the U.S. dollar. A good example is reaction to the growing concern over European sovereign debt. On March 1, 2010—when Greece first alerted the world to the bankruptcy problems facing Europe—the euro fell against the U.S. dollar from $1.3637 to $1.2309 within a span of two months. The euro eventually recovered as the European Union moved to stabilize Greece’s finances; by November 1, 2010 it was back to $1.3954.

Confidence lagged again, however, when it became clear that Ireland—and possibly Portugal and Spain—could also require emergency funding. This resulted in the euro giving up nine cents to the dollar in less than four weeks.

Central banks act as the monetary authority for their respective jurisdictions. They manage interest rates, and use direct market intervention as a powerful means to administer the economy.

Quantitative easing, for example, is used to increase the supply of money within the economy. It involves the purchase of government bonds and other assets from financial institutions, thereby providing the banking system with additional liquidity. Quantitative easing is usually a last resort if the more typical response—lowering interest rates—fails to boost the economy.

This strategy comes with some risk, however. Adding to the supply of the currency through quantitative easing could result in a devaluation of the currency.