Previously, Foreign exchange was just a concept for governments, large companies, and hedge funds, however, in today’s world, foreign exchange has become so accessible to everyone as many investment companies now offer the chance for individuals to open accounts and trade currencies anytime they choose.
Foreign exchange is the conversion or changing of one country’s currency into another at a specific rate known as the foreign exchange rate, for example, one can swap the U.S. dollar for the euro.
The exchange rate is defined as ” the rate at which one country’s currency may be converted into another.” It is important to understand how exchange rates are determined before trading.
The exchange rates for almost all currencies are constantly floating as they are determined by the market forces of supply and demand. Therefore, most countries float their currencies freely against those of other countries, which keeps them in constant fluctuation.
Foreign exchange transactions can take place on the foreign exchange market, also known as the forex market, and are handled globally between banks as all transactions fall under the auspice of the Bank for International Settlements (BIS). The most-traded currencies in the world are the United States dollar, Euro, Japanese yen, British pound, and Australian dollar.
The Foreign Exchange Market
The foreign exchange market is a decentralized market where all currency exchange trades occur. It is the largest (in terms of trading volume) and the most liquid market in the world.
In addition, it is one of the most accessible financial markets because its participants and traders range from tourists and amateur traders to large financial institutions (including central banks) and multinational corporations.
The foreign exchange market does not only involve a simple conversion of one currency into another, it also involves the application of various financial instruments, including forwards, swaps, options, etc.
The foreign exchange market is not exactly a one-stop-shop as there are a whole variety of different avenues that an investor can go through to execute forex trades.
Factors that Affect Foreign Exchange Rates
Various factors potentially influence the market forces behind foreign exchange rates. The factors range from various economic, political, and even psychological conditions.
The economic factors include the government’s economic policies, trade balances, inflation, and economic growth outlook. Political factors include political instability and political conflicts.
Inflation Rates
This major factor influences exchange rates because a slight change in market inflation can cause changes in currency exchange rates. In addition, when inflation is low, the prices of goods and services increase at a slower rate, therefore, a country with a consistently lower inflation rate exhibits a rising currency value while a country with higher inflation is usually accompanied by higher interest rates.
Interest Rates
A slight change in interest rate will affect currency value and exchange rate. This is because an increase in interest rates will cause a country’s currency to appreciate. After all, higher interest rates provide higher rates to lenders, thereby attracting more foreign capital, which causes a rise in exchange rates and vice versa.
Recession
When a country is experiencing a recession, its interest rates are likely to fall, thereby decreasing its chances to acquire foreign capital. This means that the county’s currency becomes weak compared to that of other countries, therefore lowering the exchange rate.
Terms of Trade
Terms of trade refer to current accounts and balance of payments, the terms of trade are the ratio of export prices to import prices and a trade deficit can cause exchange rates to change.
Government Debt
This refers to public debt or national debt owed by the central government and this affects the exchange rate because a country with so much government debt is less likely to acquire foreign capital, leading to inflation.
A Country’s Balance of Payments
This consists of the total number of transactions including its exports, imports, debt carried out in
a country and this reflects the country’s earnings on foreign Investment.
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