How Are Exchange Rates Determined?
Exchange rates are determined in the foreign exchange market, commonly known as the Forex or FX market. Exchange rates are influenced by factors such as economic growth, geopolitical, forces, inflation and government policies. They can fluctuate on a daily basis, but also over longer periods of time.
In this article, we’ll take a look at the factors that affect exchange rates and how they are determined in the FX market.
What Factors Affect Exchange Rates?
- Economic Performance
The economic performance of the two countries is a major factor in determining exchange rates. When one country has a stronger economy than the other, their currency will usually increase in value relative to the weaker one. This could include factors such as GDP, unemployment rate and inflation.
- Global Political Events
Uncertainty caused by global political events can lead to changes in exchange rates. For example, during the Brexit referendum, when the UK voted to leave the EU, the pound sterling weakened substantially against other currencies such as the US dollar.
Similarly, a sudden regime change can lead to significant alterations in the exchange rate.
- Differences in Inflation and Interest Rates
The rate of inflation affects the value of currencies by impacting the purchasing power of each currency. When the rate of inflation in one country is higher than the other, it will be less attractive to foreign investors, leading to a fall in its value relative to other currencies.
Interest rates also have a major role to play in determining exchange rates. Higher interest rates can attract capital from abroad, making it more expensive for those holding the foreign currency to buy the local currency. This will weaken the relative value of the foreign currency.
- Changes in Government Policies
A change in government policies can have an effect on the exchange rate. For example, if a country decides to devalue its currency, that currency will become less expensive relative to other currencies. This can be attractive for foreign investors, as they will be able to buy goods, goods and services domestically at a discounted rate.
- Speculation
Speculation can also have an impact on the exchange rate. When investors have a pessimistic outlook on the economic performance of a particular country, they may start to sell their currency holdings, leading to a fall in the relative value of that currency.
- Supply and Demand
The basic economics of supply and demand play a vital role in determining the exchange rate. When demand for a particular currency is greater than the supply, it will usually increase in value. Similarly, when the supply is greater than the demand, the value of the currency will fall.
How Are Exchange Rates Determined in the FX Market?
Now that we understand the factors that influence exchange rates, let’s take a look at how they are determined in the FX market.
- Spot Exchange Rate
The spot exchange rate is the most commonly used exchange rate and is used for immediate transactions. It is determined by the foreign exchange market, which dealers use to buy and sell different currencies. The value of the currencies is determined by global factors such as economic performance and geopolitical events.
- Forward Exchange Rate
The forward exchange rate is a rate that is agreed upon today for a transaction that will occur in the future. It is determined by adding or subtracting a premium to the current spot rate. The amount of the premium depends on the interest rate differential between the two currencies and the current spot rate.
- Interbank Exchange Rate
The interbank exchange rate is the rate that banks and financial institutions use to trade amongst themselves. It is not available to the public and can differ significantly from the spot rate due to the large size of the trades and the lack of liquidity.
Exchange rates are determined by a wide range of factors such as economic performance, global political events, inflation and interest rates, government policies and speculation. They are determined in the FX market by the spot exchange rate, forward exchange rate and interbank exchange rate. By understanding these factors and how exchange rates are determined, investors can make informed decisions about when to buy or sell currencies.
