Besides inflation, Speculation, Balance of Payments, Public Debt, and interest rates,Exchange rate is one of the most important factors that help to know the economic health of a country. In Forex trading exchange of currencies takes place. The actual exchange rate can be determined by the demand and supply of the corresponding currencies. The demand for one currency is directly connected to the supply of another currency. Currency exchange rates also affect the real return on an investor’s portfolio. Below are some of the main forces that are responsible for the movements of exchange rates.
Movements in inflation cause the changes in the exchange rate of currencies. A country having a relatively lower inflation rate will notice an appreciation in its currency values. A country showing a repetitively low inflation rate projects an increasing value of currency, while a country having higher inflation rate usually sees depreciation in its currency, which is typically accompanied by elevated interest rates. It is a very general rule that a country having lower inflation rates has higher currency value and greater purchasing power relative to other currencies.
Interest rates in Forex trading
Exchange rates are highly correlated with the interest rates and inflation. Higher interest rates cause the exchange rates to rise by attracting foreign capital. On the other hand, lower interest rates tend to reduce exchange rates. In case the interest rate of one country rises or falls in comparison to another country; the currency of the country with low-interest rate will be sold whereas the currency of the country with higher interest rates will be bought so as to gain higher returns.
Let us take an example to know the influence of interest rates on currency trading exchange rates. Suppose two countries X and Y do not use foreign exchange control and money can flow freely between these two countries. Suppose country X raises its interest rate by 1% but the interest rate of country Y remains unchanged. A large part of the capital from country Y will flow into the country X. A large amount of country Y’s currency will be exchanged for country X’s currency. This increased demand for country X’s currency will strengthen it against country Y’s currency.
Participation of the central bank in Forex trading influences the exchange rates. Usually, central bank participates in foreign exchange market by buying or selling the home currency in order to stabilize the market at a level that is realistic. Prediction by the market players on the future policy will also affect the exchange rates.
Political instability is one of the biggest enemies of any currency. If a military coup should take place in a country then it’s likely that the country’s currency will drop. This is because people are more willing to invest in stable countries. Conversely, a long period of political stability usually leads to a stable currency. High unemployment figures are usually a sign that something is wrong with the economy of a particular country. This means the GDP may also be contracting and exports falling. If so the currency in question might also drop as speculators expect the government to weaken the currency in order to help boost exports.
Financial spread betting is a leveraged product, it involves a high degree of risk to your capital and can result in losses that exceed your investment. It might not be appropriate for all types of investor. Before trading, ensure that you are fully aware of the risk. Only spread bet with money that you can afford to lose. If required seek independent financial advice. Growing political problems will result in the volatility in the Forex trading market which ultimately causes significant fluctuations in exchange rates. The stability of the currency of a country is directly related to the political condition of that country. In short, the currency of a country is stable if the political conditions of that country are stable.
Whenever a country’s economy goes into recession, the interest rates are dropped, restricting the chances of it acquiring some foreign capital. The direct effect of it is that the currency deteriorates when compared to that of some other country, thus lowering its rate of exchange.
The online trading market never follows a logical pattern of change. Exchange rates are affected by various factors such as emotions as well as economic and political events. Market operators should provide reports and data including inflation indicators, the balance of payments, economic growth rates etc. But before these data and reports become available to the common people, the market would have already made its own judgment and predictions and they are reflected in the prices of the currencies and if the actual reports and data move away too much from the judgment and predictions of the market, great fluctuations in the exchange rates take place. The exact understanding of the reports and data is not sufficient; a good Forex trading individual should understand the market reactions before the information becomes available to the public.
Balance of Payments/ Current Account
It encompasses of the sum of transactions a country does, which include imports, exports, and debt. A deficit in the current account occurs as the result of spending more on importing materials than exporting them. This directly leads to lowering a country’s rate of exchange to a stage where producing domestic services and goods become more economical than importing them, thus increasing the sale their produced goods in the international market.
Terms of Trade
Terms of trade mean the ratio that compares the export prices with the import prices. When the price of exports done by a country increases at a rate higher than the imports, the terms of trade automatically improve. The increase in the terms of trade indicates a higher demand for the country’s exports. That, consecutively, leads to a rise in the revenue from the export that then directly raises the demand for country’s currency and leads to an increase in the value.
All the factors mentioned above determine the fluctuations in foreign exchange rate and the rate of the currency in which the investor holds the bulk of their investments determines the real rate of return. Overall, the rate of exchange are arrived at by a number of complex factors and though these cannot always be explained easily, it is necessary for investors to have the knowledge of how the currency values and the exchange rate plays a role in both the rate of return on investments and also in the country’s economy.