Factors That Impact Foreign Exchange (Forex) Rates

Forex is a means to understand a country’s relative level of economic health. If you are thinking of sending or receiving money from overseas, you will keep a keen eye on currency exchange rates. This short article suggests the factors that impact Forex.

·       Inflation - changes in inflation impact exchange rate, a lower inflation (or its perception thereof) will see appreciation in the value of its currency.

·       Interest Rates – changes in interest rates affect currency value and Dollar exchange rate. An increase in interest rate causes a country’s currency to appreciate because higher interest rates provide better returns (in a relative sense) thereby attracting more funds into the country.

·     Current Account / Terms of Trade – a deficit in the current account due to higher imports of goods and services compared to export of the same causes depreciation.

Related to current account is the ratio of export prices to import prices, which are the terms of trade. A country’s terms of trade improves, if export prices rise at a greater rate than import prices. Higher revenue means higher demand for the currency and an appreciation of the exchange rate.

·     Government Debt – The level of Government debt owed by the Central Government impacts on exchange rate. If debt levels exceed prudent limits, investors flee the market and bonds (or other assets) are sold and a decrease in exchange rate ensues.

·    Political Stability and Economic Performance – A stable state with good economic performance reflects a country’s currency strength. Less turmoil is obviously more attractive (than discord). It is in the interest of political leaders then to minimise issues and create stable environment for investors.

Steady economic growth will see foreign investors vying for projects in a country. On the other hand, a downward trajectory (or expectation thereof) will weaken the currency as authorities may have to lower interest rates and provide liquidity to the system.

·        Market Makers – the Forex market is a global decentralised or over-the-counter (OTC) market for trading currencies. It is the largest market in the world.

The main participants in this market are the large international banks, central banks, institutional investors, commercial corporations, individuals and currency speculators.

Based on Bank for International Settlements data, global trading in Forex markets averaged USD5.1 trillion per day in April 2016.  In May 2016, the top three currency traders by volume were: Citi (12.9%); JP Morgan (8.8%); and UBS (8.8%).

                                                           

While exchange rates are determined by several factors, which may leave some economists in confusion, investors who have some understanding of currency values and exchange rates play a key role in determining the rate of return on their investments.

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