Exchange Rates play a vital role in the global economy, impacting international trade and overall economic stability. Numerous factors influence the demand and supply of currencies, as seen in the image below. The most important factors are interest rates, inflation rates, economic and political stability, market expectations, and market liquidity & volume.
Figure 1 Factors influencing the exchange rate of a currency| Source: Market Realist based on S&P Dow Jones Indices
Interest Rates
Central banks alter interest rates to reduce inflation and promote economic expansion. Higher interest rates tend to draw in foreign capital, which raises demand for the home currency, making it more valuable than others.
Interest rate parity is an important economic concept that suggests that the difference in interest rates between two countries will determine their exchange rate. In other words, the difference in interest rates between two nations should equal the expected change in exchange rates over a certain period in a world where exchange freely floats. Investors try to spot arbitrage possibilities in the foreign exchange market by monitoring the interest rate differentials and exchange rates. There are two types of interest rate parity: Uncovered Interest Rate Parity (UIP) and Covered Interest Rate Parity (CIP).
Uncovered Interest Rate Parity (UIP):
The difference in expected returns between two currencies should be equal to the expected change in the exchange rate between those currencies. Investors may be able to profit from arbitrage if the suggested interest rate differential by the exchange rates differs from the real interest rate differential.
Covered Interest Rate Parity (CIP):
Covered Interest Rate Parity considers the costs associated with currency risk and involves using forward contracts to hedge against exchange rate fluctuations. When the cost of forward contracts is considered, the expected return on investing in one currency, whether domestic or foreign, should be the same. There can be potential for covered interest arbitrage if this requirement is not satisfied.
Inflation Rates
A higher inflation rate relative to other countries reduces the currency's purchasing power. As a result, the currency depreciates. To protect the value of their investments, investors tend to look for currencies in nations with steady purchasing power.
Economic and Political Stability
Economic and political stability domestically and internationally can impact a currency's value. Strong economic policies and stable political environments increase investor confidence, attract demand and international investment, and support the value of the national currency. Conversely, political instability or inconsistent policies may lead to currency depreciation due to higher risk perceptions. Geopolitical conflicts, natural disasters, and global economic trends also affect investor sentiment and risk perceptions. Safe-haven currencies like the US dollar and Swiss franc can appreciate during uncertain times.
Moreover, the strength of a country's currency is strongly influenced by economic conditions, such as GDP growth, employment rates, and consumer spending. A strong currency typically reflects confidence in the country's prospects and results from excellent economic performance.
International trade also plays a role in the valuation of a currency. The difference between imports and exports, or a nation's trade balance, affects the value of its currency. When exports exceed imports, there is a trade surplus; when imports exceed exports, there is typically a currency depreciation.
Governments can sometimes intervene in the market to stabilize their currency or obtain a competitive edge in international trade. Exchange rate fluctuations can be influenced in several ways. Common methods of intervention include:
- Foreign exchange reserves management
- Varying monetary and fiscal policies
- Direct market intervention by buying or selling currencies
- Capital control by restricting the flow of capital in and out of the country
- Pegging exchange rates
- Coordinating with other central banks
Market Speculation
Traders and investors may speculate on currencies, which may result in brief changes in exchange rates. Geopolitical events, market sentiment, and assumptions about future economic conditions can influence speculative behavior.
Market Liquidity and Volume
Trading volume and market liquidity can affect changes in exchange rates. More trading activity and liquidity in currency markets usually translate into exchange rate dynamics that are more efficient and stable.
To effectively expect and manage exchange rate risks, investors must thoroughly understand these elements and how they interact. In an interconnected world, specific forces shape the trajectory of currency markets over the long term, while others may be more direct and immediate.
The content published above has been prepared by CFI for informational purposes only and should not be considered as investment advice. Any view expressed does not constitute a personal recommendation or solicitation to buy or sell. The information provided does not have regard to the specific investment objectives, financial situation, and needs of any specific person who may receive it, and is not held out as independent investment research and may have been acted upon by persons connected with CFI. Market data is derived from independent sources believed to be reliable, however, CFI makes no guarantee of its accuracy or completeness, and accepts no responsibility for any consequence of its use by recipients.