Factors influencing exchange rates

Factors influencing exchange rates

The main factors influencing the exchange rates are:

  • 1.What is traded internationally
  • 2.Interest
  • 3.Price level
  • 4.Speculation
  • 5.National income
  • 6.Political factors
  • 7.Discovery of resources

A warning If you open an account with a forex broker to speculate with foreign exchange, you will receive an email from the broker with this sentence: “73.62% of retail client investors lose money when trading CFDs with this provider.
Brokers are legally obliged to inform their clients of this fact. Despite the complexity of the exchange rate changes, it can be clearly said that the exchange rates change due to changes in the offer and the
Move demand for a currency. (Of course, this only applies to flexible exchange rates, as was explained in the former article, What is the foreign exchange market?). Now we just have to ask:

Which factors change the demand and supply of a currency?


Each market works through the interplay of supply and demand, which are shown in a simple graph below (Image 1A). Where supply and demand intersect, one arises.
Market balance: Q * € is the amount of balance that is sold and bought. (€ / $) * is the equilibrium price (in this case the equilibrium exchange rate).

As with all goods, the following also applies to currencies:
• The greater the demand or the lower the supply of a currency, the more value it gains (appreciation) against other currencies (it becomes “more expensive”; Image 2A).
• The lower the demand or the greater the supply of a currency, the more value it loses (depreciation) compared to other currencies (it becomes “cheaper”; Image 2B).

2A and 2B shifts in the demand and supply curve. (Source: own illustration)

What are the influencing factors?


The factors influencing the demand and supply of currencies – factors that shift the demand or supply curve so that a new balance, thus a new price, in other words a new exchange rate, are created( Image 2C):

  1. What is traded internationally shows the preferences of consumers.
  2. Interest (comparison of domestic and foreign interest)
  3. Price level (or inflation in the different countries)
  4. Speculation
  5. National income (or GDP, comparison of growth rates at home and abroad)

These seven factors alone can be used to explain and forecast many movements in exchange rates. The important thing with Forex is the difference between short-term and long-term forecasts. Short-term movements are unpredictable: Minutes, hours, a day, a week are often like a casino game1.

  1. Political factors (stability or instability)
  2. Discovery of resources

These seven factors alone can be used to explain and forecast many movements in exchange rates. The important thing with Forex is the difference between short-term and long-term forecasts. Short-term movements are unpredictable: Minutes, hours, a day, a week are often like a casino game1.

Ceteris paribus


In economics, the so-called “Ceteris Paribus” clause (English: all other things being equal) is used to analyze systems with different variables (the factors mentioned above). This means that only one variable, for example interest, is changed in the system and the effects of the change on the entire system can be observed (e.g. we are interested in how interest rates change affect the exchange rate) while keeping all other variables constant. To analyze the factors influencing exchange rate changes, we will always use “Ceteris Paribus” (all other things being equal). If we e.g. For example, if we want to analyze the effect of an increase in interest and income on the exchange rate, we have the problem that we do not know whether the change in the exchange rate is caused by interest and / or income. Therefore you should only change one variable, all other things being equal. There are some other factors such as. the money supply or the capital movements. To explain this would go beyond the scope of this essential.

Preferences (international trade)


What interests us here are the preferences of the consumers, in other words the demand curve. Let’s assume that the car preferences of Americans are changing, so that the demand for German cars is increasing. The American Importers have to pay German car manufacturers in Euros. This means that they first have to change their US dollars to Euros. This in turn means an increased demand for Euros. (Image 3A) Corresponds to the increased demand after the Euro a shift in the demand curve to the right; more Euros are requested at any given exchange rate between the Euro and the US dollar. As with any market, the demand for a product increases also the price of this product (ceteris paribus). In the case of a currency, their exchange rate increases, and there is an appreciation: In the initial balance, you pay 1.05 USD for 1 EUR, in the second balance you pay 1.18 USD for 1 EUR In summary, our assumption is that the popularity of German cars is increasing among the Americans. The demand for these cars is increasing and so is the demand for the Euro to pay the German car exporters. Thus, the value of the Euro increases in the foreign exchange market that of the USD $, which means an appreciation of the eEuro.

interest

(Image3B) Devaluation of the USD. (Image 3C) USD appreciation. (Source: own illustration)

This increased demand for the Euro in the American market brings with it an increased supply of the US dollar in the European market (the Americans have to sell their dollars to buy Euros). An increased offer corresponds to a shift of the supply curve to the right. And as with any product, the price drops as the offer increases. A lower exchange rate of the US dollar against the Euro means a depreciation of the US dollar. Because as we have seen in the former article, what the foreign exchange market is about, currency pairs are traded in the foreign exchange market, which logically means that if one currency appreciates, the other must depreciate (Image 3B)
If we want to save money, we open a savings account and after a while we get additional money in the form of the interest that the bank pays us. When we take out a loan, we pay attention to the interest that we have to pay back on the loan. In a global world, we not only take into account the interest rates offered by the banks in our country, we also compare them with those in other countries. If, for example, interest rates are 6% in Sweden and 2% in Germany, then it is clear that we would rather invest savings in Sweden than in Germany. The first thing would then be to change Euros into Swedish Krona. If a lot of money flows to Sweden because of the higher interest rates, the demand for Swedish Krona in the foreign exchange market increases (this corresponds to a shift of the demand curve in ( Image 2C ) to the right, only with the difference that these are USD and EUR, not SKR).

A higher demand for Swedish Krona means, ceteris paribus, that their value would increase against the Euro, and the Swedish Krona would appreciate: I now get less Kroner for one Euro. The same circumstances apply to loans. Nowadays, you not only take out loans in Germany, but compare them with other countries, where you may have to pay lower interest rates. There are countless internet portals compare interest rates from different lenders within seconds. If the interest on loans is 1.5% in Switzerland and 3% in Austria, many Austrians will take out their loans in Switzerland. So increases
the demand for Swiss Francs (CHF). Accordingly, as in the example of the Swedish krona, the Swiss franc will appreciate against the Euro. The Austrians used this situation before 2015 to take out cheaper loans in Switzerland, for example to increase real estate in Austria acquire. However, this investment ended in disaster for many of the Swiss franc borrowers. On January 15, 2015, the Swiss National Bank lifted the minimum euro exchange rate. The Franc rose to one blow by almost 20%, which made repayment of the loan massively more expensive (you suddenly needed more Euros to repay the Francs; the property purchased had become 20% more expensive!). And who determines the interest?

Central banks have the power to set the interest rate

  • The European Central Bank (ECB) for the Euro area
  • The Bank of England (BOE) for England
  • The Federal Reserve (FED) for the USA.

Each country has its own central bank. The fight against inflation is their main job and a key tool to fight inflation is the rate set by the central bank.

Summary The international interest rate differential conducts, ceteris paribus, the movements of exchange rates. Raised interest rates mean higher returns for savings, but also higher costs for borrowers. These two forces affect the exchange rate.

Price level (inflation differential)


Another factor that has a strong impact on exchange rates is prices, or more simply, inflation. As already mentioned, the central banks’ main task is to fight inflation. To this the interest rate is used for this purpose, which in turn moves the exchange rate. Now we compare the domestic and the foreign price level and use it to calculate the so-called inflation differential. For example, if prices in the United States increase more than in the Euro zone, Europeans will buy fewer American products and Americans buy more European products because they are cheaper, assuming that the inflation rate in the Eurozone is lower than in the United States. This in turn means increased demand for Euros (in other words a shift in the demand curve for the Euro to the right and accordingly an appreciation of the Euro against the dollar, ( Image 2C ).

The thought process is therefore always the same: demand (or supply) increases or decreases, which in turn means ceteris paribus that the demand curve turns to the right (increased demand) or to the left
(reduced demand) shifts (the same applies to the supply curve).

speculation


The speculators follow a simple philosophy: buy cheap, sell expensive.

To put it more formally, speculation means: striving for profit by taking advantage of price differences between purchasing and selling.

You don’t act to deliver goods, but because you expect that it becomes more expensive (you buy now and sell later) or it becomes cheaper (you sell now and buy later). You can speculate with practically every commodity – art, coffee, stocks and of course foreign exchange. Currency speculation means buying or selling a currency in the expectation that their exchange rate will increase (when buying) or decrease (when selling). When the exchange rate rises, the currency is sold to make up for the profit; if the exchange rate falls, the currency is bought back at a lower price. Sounds easy, but has a lot of people in it financial ruin.

An example


We buy € 100,000 for $ 1.12, which is $ 112,000, with the expectation that the EUR will rise. After two weeks, the exchange rate is $ 1.19 per EUR. We sell our EUR and get $ 119,000. A win of $ 7,000 or 6.5% in two weeks.

Speculators, especially the most powerful, like George Soros, can use their interventions in the foreign exchange market to determine or at least massively influence exchange rate changes. A simple little investor who speculates has no influence whatsoever on what’s going on in the markets. In a hypothetical scenario, it would be possible for all participants in the foreign exchange market to believe that the US dollar will lose value. Everyone would sell, no one would buy, and the value of the US dollar would decrease (a classic example of massive speculation). The result is a devaluation of the US dollar just because speculators believed that the US dollar would lose value in the future. The same can happen in the other direction: If For example, everyone believes that the Japanese yen will gain in value, the demand for the Japanese yen (JPY) increases and the Japanese yen appreciates.

Speculative attacks


Sometimes there are direct attacks against a currency, this is called “speculative attacks”. One of the most famous attacks against a currency was against the British pound, carried out by George Soros and other powerful speculators in 1992. George Soros believed that the British pound (GBP) was overvalued and started selling GBP massively. Many great speculators followed him. The Bank of England tried to support the GBP with billions of dollars in purchases, but failed, the GBP was depreciated. Then Soros bought the GBP at a greatly reduced price. George Soros is said to have made billions from this operation.


How does a targeted speculative attack work?


Let’s assume the following scenario: The currency (called Lirax) of a country (called Xax) loses value due to political instability. The inhabitants of the country Xax sell their Lirax because they are afraid of increasing instability. This massive sale to Lirax leads to a downward spiral. The central bank of the country Xax sells its international currency, say the US dollar, and buys its own currency, its Lirax,
to artificially maintain their value (as shown in former article, central banks are major players in the forex and hold reserves of major currencies). (2 major US investors, born in Hungary, one of the most powerful speculators in history.) International speculators see the opportunity in this scenario as a profit to achieve through speculation by “bleeding” the central bank – something more formal:
The speculators sell more lirax to deprive the central bank of reserves to support the lirax. The speculators go to the country of Xax, take out a loan in Lirax and sell it on immediately. The supply of Lirax is increasing, with the result that its value continues to decline and the central bank will continue to spend its reserves. Now the speculators have exchanged their borrowed lirax for US dollars, while the central bank has exchanged all of theirs, has used up reserves and the value of the Lirax continues to decrease. The speculators are now buying back the very cheap Lirax, repaying their outstanding loans and carrying their high profits abroad. The Lirax has lost massive value the country Xax can no longer afford foreign products. The unrest among the population increases, which in turn increases political instability, chaos breaks out in the country and the further downward spiral is difficult
to brake (e.g. by a military coup [common in Latin America and Africa] or by a foreign military intervention that the US prefers for the Venezuelan crisis).
Such targeted speculative attacks can have drastic consequences for the “victim country”. Due to the massive loss in value of their own currency, the prices of imported products rise sharply. The prices of medicines and other vital goods would then rise. Such massive speculation can also have long-lasting ramifications for a country’s banking system. Once this has collapsed, the economic crisis is exacerbated by something else. In addition, these speculations at flexible exchange rates, where there is in principle no central bank intervention in the foreign exchange market, can affect international trade:
e.g. B. lead to export restrictions and import expansion due to speculative revaluations or inflation tendencies due to speculative devaluations (so maybe in the case China and the United States in the current trade war).

National income (GDP)


Gross domestic product is the monetary number of all goods and services that are produced in a country in one year. Not only those goods and services that are consumed or used in their own country, but also those who go abroad, in other words exports. The growth rate of GDP tells us whether an economy is in an upswing or downswing. The growth rate of an economy has an enormous impact on that Exchange rates. If you wanted to make it extremely simplistic, you could compare a country’s GDP to a person’s income (I repeat, an extreme simplification, but didactically useful). The higher the income, the higher the consumption. You may only buy a car then, but it will likely be more luxurious. The following applies to an entire economy: the higher the GDP growth rate, the higher the
consumer spending, not only in relation to national products, but also to foreign products (imports), which in turn leads to increased demand for foreign currency (Shift of the demand curve to the right by foreign currency. Foreign currency right. That means, ceteris paribus, an appreciation of the foreign currency.

Simply represented:


↑ growth rate ⇒ ↑ consumption ⇒ ↑ imports
⇒ ↑ Demand for foreign currency
⇒ appreciation of the foreign currency

Summary When comparing the GDP growth rates of two countries, it can be expected that the value of the currency with the higher growth rate will depreciate against the currency of the country with the lower growth rate.


Political factors


As we have seen in the context of speculation, a country’s political instability has a huge impact on the exchange rate. Investors, not just speculators, lose confidence and leave the country (their capital is withdrawn) or the capital inflow is throttled. The currency continues to lose value due to the capital outflow, which in turn is ideal conditions for speculation with the consequences that we explained in point 4. The return of political stability does the opposite: investors return, capital inflows increase and the currency recovers from its weakness.

Discovery of natural resources


If a country discovers resources for which there is international demand (e.g. oil), its currency will appreciate as other countries will buy that currency to pay for the newly developed resources. Compared to the other factors, the frequency of this factor and its impact on the foreign exchange market is low. But in the other article we will talk about, Theories and models to explain exchange rate developments.

What can you do to make these factors influencing exchange rates work for you?

Now that we know what influences the markets, you’re already far more prepared than the majority. From here, you can use these factors to your advantage when planning a currency strategy that uses any potential volatility to your advantage.

For example, by partnering with a global money transfer specialist, such as OFX, when dealing in different currencies around the world, you can take advantage of tools designed for that specific purpose.

Forward Exchange Contracts for example, allow you to lock in an exchange rate if it suits your transfer needs and then transfer the funds at a later date, even up to 12 months in the future. For example, if you needed to transfer money from USD to GBP and the GBP drops drastically, like it did when the Brexit referendum outcome was announced, a Forward Exchange Contract may help.

OFX also offer other tools that can help you manage your global money transfer needs. Find Out More Here

By S.van der Tap Pd.Internet Marketer Founder Of digitalstico.com

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