What Determines Foreign Exchange (Currency) Rates

Fariehaz, in my original entry on FOREX trading, asked me a couple of questions. They were:

1. What determines Foreign Exchange rates.
2. How currencies are pegged.

In this entry, I will address the 1st question. I will keep it as simple as possible. Only basic explanations will be provided. No in depth explanations will be done in this entry.

There are number of factors that contribute to changes in Forex rates. Below are some of them.

1. Interest rate movements

A rational investor will often look for the best place, in terms of returns, to park their money. If interest rates were high and outlook for the stock market is grim for example, then currency might be the better option (more attractive). Then, currency becomes more expensive due to the high demand..

Also, if you look at two countries. For example, the United States of America and Australia. Australia, at the present moment, has a higher interest rate than the US of A. Thus it makes more sense to park money here in Australia than in the US, thus earning a higher interest. Again, this will drive US Dollars down and push the Aussie Dollars up. This is what you call as… CARRY TRADE.

2. Central Banks Manipulation

A Central Bank can be a major player in the Forex market. It can buy and sell large sums of currencies to manipulate the market. There are many reasons to why central banks do this, but they will not be discussed here.

Bank Negara Malaysia was an influential player in the Forex market, to the point of getting a warning from Alan Greenspan, the then chairman of US Federal Reserve.

Also, referring to the 1st factor of interest rate movements, the central bank is the setter of interest rates.

3. Speculators/Traders

Pretty similar with above, the big players in the market like institutions or just people with heaps of money, they can influence forex market movements by buying or selling large sums of currencies.

4. Unexpected News Announcements

Any unexpected political and economical news announcements can also cause movements in the Forex market.

5. Balance of Payments

Okay, this involves a few jargons like balance of payments, export, import, current accounts, deficits, and surpluses. I’ll just put them in an example.

Suppose a country is exporting goods & services more than it is importing, resulting in more money coming into the country. In this instance, the state of current account surplus is to be expected (let’s just assume that is in in surplus). Large current account surplus will make the currency to appreciate.

Contrast this with a country that imports more than it exports (i.e. more money going out than coming in), in which current account deficits will exist (let’s just assume that it is in deficit). In this instance, the currency will depreciate.

All in all, we can conclude that at the end of the day, Forex rates are determined by supply and demand. If there is a high demand for a particular currency, it will appreciate. If there is a low demand for a particular currency, it will depreciate.

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Disclaimer: This article is not a specific nor general advice on managing or investing your money. This article does not constitute a recommendation nor does it take into account your investment objectives, financial situation nor particular needs.

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About nadlique

This blog is about the journey of a 28-year-old Malaysian towards financial freedom. This blog was started back when the blogger was 21 years old. However, his journey towards financial freedom had begun way before that. Materials such as investing, business, entrepreneurship, equities, and real estate are presented. The author also posts his thoughts and observations on life in general.

Comments

  1. This is really a good post on what determines foreign exchange rate. I just still have a little confusion. Does this system (which calculate the rate) is worldwide or country specify? If I change RM3 for USD1 in Malaysia. Does I change USD1 for RM3 while I’m in U.S.?

  2. If I’m not mistaken, fundamentally, all the rates are the same. i.e. if you exchange RM3 for USD1, it’ll also be the same as USD1 for RM3.

    However, there’s another thing that needs to be thought of. When it comes to us, the consumers, the rates we’ll be getting is different.

    Like for example, if you’re a Forex trader, the rates you’ll be getting will be up to your Forex provider. This depends on the spread.

    Another example, If you change your money to go for a holiday, the rates you are getting depends on your money changer. You might see money changers in US taking more profits than the ones in Malaysia. So, the actual fundamental rate might be RM3 for USD1, but it might be RM3.20 for USD1 at the money changer in Malaysia and RM3.50 for USD1 at the money changer in the US.

    So, yes, I think it will be different exchanging money in Malaysia and the US but it’s not because of the actual fundamental rate but rather, it’s because of the rates set by the parties involved.

  3. So there is a system (e.g super computer) to compute this rate based on the supply and demand? So this system is worldwide and they synch up everyday?

  4. I’m not so sure as to how the rates sync up but I think there is indeed a system involved based on supply and demand of currencies.

  5. Maybe when there is a time out-of-sync, the actually fundamental rate will be different. I just curious how they do that. The person who design the system, could they have better change to predict the rates?

  6. Another thing to consider is that currencies do not have any proper exchange like Bursa Saham KL or Wall Street. It’s an open market.

    So, who actually keeps track of things, I wouldn’t have a clue. Might need to read more on this.

  7. If no proper tacking, does that mean the actual fundamental rate could be different too? 🙂 I really have no idea too. Same here, I will do more research on this. Easy way I would just wait for you to figure that out. Hahaha…

  8. Per my knowledge, foreign currency is very much lika other close ended investment like share/commodities. The foreign exchange market’s demand and supply will determine the currency value. For eg, if our Bank Negara would to pour more Ringgit into the open market, it will increase its supply and hence reduce the value. Or buy it to raise the value. Hence its underlying value is determined on each trading day just like normal shares market.

    For eg, when USA reducing its interest rate, it is no longer attractive for the investors to hold on to the dollars and they will try selling it off in the foreign exchange market. The urgency of selling will cause the dollar’s value reduced as what we are seeing now. So, the value is being determined by the world’s foreign exchange’s markets.

  9. I think what ChampDog meant was, who keeps track of things. Like stocks in Malaysia, the KLSE. In the US, NYSE. In Australia, ASX. For stocks, there are dedicated institutions.

    For currency on the other hand, there are no central exchange at all. So, how do we sync up with the whole world.

  10. From what I understand, for forex trading, it is mostly done over the counter; ie banks go directly to each other and trade. I heard from one of my friend whom is forex dealer for a reputable bank, there are also some foreign exchange futures listed in CME (Chicago Mercantile Exchange), which is quite similar to our share trading. However, not all the currencies are listed on CME though.

  11. Check out this statement:

    The forex market can be split into three main regions: Australasia, Europe and North America. Within each of these main areas there are several major financial centers. For example, Europe is comprised of major centers like London, Paris, Frankfurt and Zurich. Banks, institutions and dealers all conduct forex trading for themselves and their clients in each of these markets.

    Full article is here:
    http://www.investopedia.com/ask/answers/05/forex24hoursaday.asp

    Read the last 2 paragraph, I guess this article explains everything.

  12. Thanks! ChampDog

  13. Thanks for sharing ChampDog.

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