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.


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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