Top 5 factors that affect exchange rate

1. Interest and Inflation rates
2. Trade balance
3. Currency market speculation
4. Foreign investment
5. Central bank market intervention

1. Interest and Inflation rates

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.

Since interest rate, inflation and exchange rate are all highly correlated, central banks can intervene in both inflation and exchange rates by manipulating interest rates. The importance of interest rate as a control is quite evident from the attention that the Federal Reserve's interest rate announcements get. Higher interest rates attract foreign investments and lead to currency demand increase, which in turn results in exchange rate increase. However, if inflation in the higher interest rate economy is much higher than in others, the benefit from higher interest rate is mitigated because high inflation drives down exchange rate as described before.

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.

2. Trade Balance

Trade balance (or balance of trade or net exports) measures the ratio of exports to imports for a given economy. It demonstrates the demand of that country's good and services, and ultimately it's currency as well. If exports are higher than imports, a trade surplus exists and the trade balance is positive. If imports are higher than exports, a trade deficit exists, and the trade balance is negative.

   Exports > Imports = Trade Surplus = Positive (+) Trade Balance
   Imports > Exports = Trade Deficit = Negative (-) Trade Balance

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.

Current account deficits

In long term perspective, current account surplus or deficit and the exchange rate has a strong correlation. But there may not be any causal relationship.

Under a fixed exchange rate regime, a country's current account short-term surplus or deficit has little effect on the exchange rate. China is an example. Its huge current account surplus and foreign exchange reserve have no strong effect on Yuan’s exchange rate.

In the floating exchange rate system, the current account status affects a country's exchange rate to a certain extent. In general, the current account surplus will lead to appreciation of home currency, while deficits will lead to devaluation of home currency. A deficit in the current account means the country is buying more in international trading than it is selling. Therefore, the country needs more foreign currency than it receives through selling through exports. The excess demand for foreign currency lowers the country's exchange rate. But this effect is mainly in long term perspective. The biggest short term impact on a country's exchange rate is macro-monetary policies.

Public debt

Some countries pay for public sector projects and government funding through a large-scale deficit financing. Although this activity stimulates the domestic economy, countries with high debts are less attractive to foreign investors. Why? Large-scale debt encourages inflation. If inflation is high, debt service is ultimately cheaper to pay in the future in the real dollars.

In the worst case, the government can print money to pay for a large part of the debt. But increase the money supply will inevitably lead to inflation. In addition, if the government cannot service by means of domestic deficit (selling domestic bonds to increase the money supply), it must increase the supply of securities sold to foreigners, thereby reducing its price. Finally, a major concern of the debt to foreigners is the risk of default. Foreigners will be less willing to buy securities denominated in that currency, if the default risk is high. For this reason, the country's debt rating would affect the exchange rate too.

3. Currency Market Speculation

Since the inception of the floating exchange rate system in 1973, speculation in the foreign exchange market has intensified. Speculators in the foreign exchange markets are often strong enough to push the exchange rate far away from its equilibrium level. They often take advantage of market momentum to attack a currency. Sometimes this kind of attacks is so strong that even the joint central bank intervention of the seven western countries in foreign exchange market cannot stop it. Appropriate level of speculation contributes to an active foreign exchange market. But excessive speculation increases foreign exchange market volatility and distorted foreign exchange supply and demand.

In addition, the foreign exchange market participants and researchers, including economists, financial experts and technical analysts, traders follow the currency markets trend every day. Their judgments on the market affect market psychology of traders. This is an important factor for short-term fluctuations of the exchange rate. When the market expects a currency to be weaker, a large number of traders will sell the currency, resulting the depreciation the currency. One the other hand, when people expect a currency to be stronger, there would be a lot of buying of the currency, making it more valuable.

4. Foreign Investment & Capital flow

Investors make investment decisions based on two driving factors – "the level of risk" and corresponding "level of return". When a country meets their expected levels of risk-return ratio investors come in and demand for assets in the country rises. Central banks monitor and sometime control the flow of money in and out the country. For this reason most countries hold significant forex reserves. China and Russia alone hold well over a trillion U.S. dollars in their foreign currency reserves.

Let's look at an example: 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.

Similarly when an economy is growing rapidly as in places such as China, India and Brazil; more foreign investments flow in. With more investment coming into a country, demand increases for that country's currency as foreign investors have to sell their currency in order to buy the local currency. This demand causes the currency to increase in value. This follows the Simple supply and demand principle.

5. Central Market Bank Intervention (Quantitative Easing)

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 by some central banks to stimulate their economy. The central bank creates money which it uses to buy government bonds and other financial assets, in order to increase the money supply and the excess reserves of the banking system; this also raises the prices of the financial assets bought (which lowers their yield). 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.

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Top 5 factors that affect exchange rates ...

There are many factors that affect exchange rates of currencies. However some are more important in currency trading than others. These are; Interest and Inflation rates, Trade balance, Currency market speculation, Foreign investment and Central bank market intervention. Learn how to use these factors in your forex tra ...

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