July 31, 2014

FX rates demystified

Understanding what causes a change in FX rates can be difficult, as there are so many actors affecting the FX rate on any given day. It is estimated that the Foreign Exchange market can see as much as $4 trillion exchanged each and everyday, which far outweighs the highly publicised stock exchanges.

Supply and Demand is king

The age-old concept of supply and demand is key to FX rates. For example, if a currency is in high demand, it’s value will obviously rise as more people desire it. This is a common underlying principle of goods and services in the marketplace too.

Concept of a ‘safe haven’

During difficult economic times, investors often look to ‘safe havens’ for their money in order to limit their risks. Commonly, this can see investors seeking bonds issued by ‘strong’ governments such as Japan. As more investors demand the bonds, this can result in an increase in the strength and value of the Japanese Yen in this example. However, there are far more factors at play in terms of determining a ‘safe haven’, most noticeably the perceived prospects and stability of an economy.

Rate of inflation

The rate of inflation can have an effect on the FX rate and value of a particular currency. For example, a country with low inflation should experience its currency being able to buy more than its peers who may be experiencing higher rates of inflation and thus getting less for their currency.

Trade, speculators and investment

In similar fashion to stocks, FX rates can also be affected by trading, speculators and investments. If there is a perceived increase in demand, then this will drive up the value of a particular currency. High growth areas such as some emerging markets are expected to see their currency rise in value against the likes of GBP and USD as a result of increased investment and trade flows. Although it is important to understand that trades and speculators can often change the value of a currency in the short-term only.

Role of interest rates

Interest rates can be a major influence on FX rates and the value of a particular currency. For example, interest rates in the UK have been at their lowest level in many years. Therefore, investors may look to countries offering higher rates of interest in order to enjoy better returns. Again, a higher rate of interest will most likely result in a higher rate of demand, thus increasing the valuation of a particular currency.

There are also a number of affecting factors such as political issues, but as outlined initially, the concept of supply and demand is crucial to movements at all times.