the foreign exchange rate

Factors Affecting Foreign Exchange Rate & Currency Value

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A country’s economic health can be determined by assessing its domestic currency exchange rates. This because foreign exchange rate of world currency is a crucial component in international trade of free market economy. However, exchange rates play a role on a smaller scale as well. In fact, it can even impact the returns on an investment portfolio. This article points out the factors affecting the exchange rate of Forex pairs.

What is Exchange Rate & Currency Value

The currency exchange rate is the value of one Forex currency expressed in other Forex currency. The international currency market is based on Forex pairs traded on different Forex rate of exchange. Every Forex currency value is quoted in other currency.

currency value foreign exchange rate

For example let’s take the Euro foreign exchange rate expressed in US Dollars. This is called the EUR/USD Forex pair. Let’s say the foreign exchange rate today of the EUR/USD is $1.0600. This means that one Euro costs 1.0600 in the Dollar exchange currency.

But the Euro could be quoted in other Forex currency as well, like the Great Britain Pound for example. This creates the EUR/GBP Forex pair. This currency couple quotes the EUR currency value in GBP, which is £0.8513 at Nov 29, 2016.

6 Factors Affecting the Forex Currency Foreign Exchange Rate

Global exchange rates of currency pairs are determined by the supply and demand factor concerning every single currency. Buyers represent demand and sellers represent supply. When Forex market players are investing in currency they create supply and demand pressure, by buying and selling different Forex pairs. This causes the world currency exchange rates to fluctuate.

euro exchange rate

Yes, but investors are not randomly buying and selling different currency pairs. Their decisions are based on domestic factors, concerning the economy (country) represented by every single currency. If you possess US Dollars, then the US economic performance should be in your focus. If you have Dollars and something bad happens to the US economy, then investors is likely to withdraw their trust from the USD creating a selling pressure. This is likely to depreciate the USD since a lot of USD supply will be created on the international currency market. As a result of this, your US Dollars will worth less in other currency.

If you own Euro, then you should follow the economic results of the European Union. And if you own Japanese Yens, then Japan should be the primary economy of your interest, and so on.

Today we will discuss the top 6 economic factors affecting the foreign exchange rate of world currency pairs.

Factor 1: Inflation

forex inflation

In general, a country that is able to maintain a low inflation rate will boast a healthy currency value, because it means national purchasing power increases relative to other currencies. The higher the rate of inflation, the more a country’s currency will depreciate in comparison to the value of other currencies.

Factor 2: Interest Rates

forex interest rates

Central banks control the rate of inflation and the cost of exchanging currency through the authority to adjust the interest rate. A high interest rate offers to lenders significant returns in relation to other countries. Therefore, it’s possible to mitigate the effects of a high interest rate. This is only if inflation is higher than it is for other trading partners, or if outside factors devalue the rate exchange of the currency. The opposite is true for decreasing interest rates.

Factor 3: Account Deficits

account deficit

The balance of trade lies in the relationship between a nation and its partners, which encompasses all trade between countries in terms of the goods and services. If there is a deficit in the account, it indicates that the country is importing more goods and services than it exports. To bring the account up to par, the country would usually have to borrow capital from foreign entities. Inflation ensures as their currency would depreciate in relation to its trading partner.

Factor 4: Public Debt

forex public debt

Typically, countries utilize large-scale deficit financing in order to complete ambitious projects with the use government funds. Although these projects are a major boon to the country’s economy, a nation that runs a deficit will draw less attention from overseas investors. This is because when investors see debt, they think inflation, which translates into a lower currency value.

Factor 5: Terms of Trade

terms of trade

The terms of trade is a ratio used to compare the price difference between exports and imports. If the price to export rises at a higher rate than imports, then the country’s terms of trade have significantly improved. This is likely to result in currency rate exchange appreciation. However, if the price of a country’s imports rises more than the rate of exports, their currency value will decrease in relation to trading partners.

Factor 6: Political Stability and Economic Performance

political stability and economic performance

Overseas investors prefer countries that are and have a high economic output. For example, instability in a country’s government can lead to a loss of confidence in their currency. Investors will then shift to countries that has stability and a strong economy.

The Bottom Line

The foreign exchange rate of currency influences the return on a portfolio that includes the quoted currency. A foreign exchange rate is intertwined with factors, such as the rate of inflation and interest rates.

A Forex trader who deals with international currency exchange should always monitor the economic factors concerning currency value. These are essential for realizing profit on the foreign currency exchange market. Not knowing the performance of leading economies usually leads to Forex loss and failure in currency investing.

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