What Influences Exchange Rates?

What are Exchange Rates?

An exchange rate is the relative ratio that one can exchange a unit of one currency for a unit of another currency. For example, the USD/CAD exchange rate is the quoted rate of exchanging one US Dollar for one Canadian Dollar.

This ratio is determined by market forces that look at the relative supply and demand of one currency relative to another to determine the quoted price.

The act of exchanging one currency for another is also known as Foreign Exchange (Forex or FX) and can be one of the simplest concepts to grasp but most difficult to master. Many of us use FX when we exchange our local currency for foreign currencies to pay for internet purchases from overseas or when we travel abroad. FX has been around for centuries, pretty much since the invention of money, but it still forms the very basis for many economic decisions today.

For investors, trading currencies is one of the most difficult and not for casual investors. To invest well, you must understand the risks associated with FX markets. And you must understand what events will impact market rates so that you are ready to take profit where it is available and limit your potential losses.

Trading Forex

Before delving into what causes Forex prices to move, it is helpful to review exactly how the market works.

Investors new to the FX market may be surprised to learn that it is the largest market in the world, generating over $6 trillion[1] in transactions daily (more than five times the turnover 20 years ago). It is also a highly liquid market, far more so than equity and debt markets. And unlike other markets, transaction costs are very low due to the very tight bid/ask spreads in FX markets.

Forex trading revolves around currency pairs, such as US Dollars and Euros (USD/EUR) or US Dollars and the Japanese Yen (USD/JPY). And since the currency pair works in either direction, a trader can either buy or sell the base currency versus the quote currency – meaning that he or she can easily go either long or short a currency relative to another. As the values of currencies change against each other, investors can profit from their relative movement. 

Take a quick example, using the dollar movement against the euro in 2022. On January 3, if you bought 1,000 euros, it would have cost you USD1,128.89 (assuming you got the prevailing market rate and paid no commission). But the dollar strengthened against the euro over the year, and by October 31 of this year, those USD dollars were worth 1,142.32 euros, a 14% profit over that period.

Additionally, many FX traders use leverage to amplify potential returns, which leads to increased losses should the trade not work out.  Popular FX trading platforms, such as Interactive Brokers, Forex.com, and OANDA, charge interest on these margin accounts.

Forex markets move very quickly, and trading is essentially 24 hours a day, driven by exchanges in New York, London, Tokyo, and Sydney. So FX investors need to keep an eye on potential price drivers across the globe.

Drivers of Exchange Rates

As with any other investment product, the movement of currency prices is complex and depends on many different factors. Here are some of the more important factors:

Purchasing Power Parity (PPP)

The oldest attempt to explain exchange rates is the purchasing power parity theory (PPP).  PPP is more of a general economic theory than a specific price driver, but it provides a useful starting point for understanding currency markets, especially for new currency investors. According to the PPP principle, exchange rates should move so that similar products require the same amount of purchasing power in every country. Deviations can tell investors if currencies are overvalued or undervalued and suggest which direction rates may move.

In 1986, the Economist magazine simplified this theory in a way that every investor could understand by launching the “Big Mac Index.” In July 2022, the average U.S. price of a Big Mac was $5.15. In the Eurozone, Big Macs ran €4.65. The prevailing exchange rate was 0.98 euros per dollar. But the relative prices indicated an exchange rate of 0.9, suggesting undervaluation of the euro against the dollar.

Inflation also impacts exchange rates more indirectly. For example, as rates rise, credit usage often increases[2], driving consumption and potentially indicating a rise in value that is reflected in further increases in exchange rates.

Just as stock markets never perfectly reflect all available information, neither do currency markets. So while the PPP is a helpful guide, and over the longer term of years and decades, one would expect a sort of equilibrium in PPP to develop; investors should not view it as their sole data point for market price movement.

Economic News and Data

It should be no surprise that economic news and data impact the currency markets in much the same way it affects equities. The primary economic news for the past year has been inflation and interest rates. Both have risen dramatically across the world during 2022.

As interest rates increase, investments in a given country become more attractive, resulting in more money flowing into the country. As a result, demand for the local currency also increases, driving its value up compared to other currencies.

More advanced investors can use interest rate information to predict exchange rate movement using the interest rate parity (IRP) theory. IRP theory predicts future exchange rates based on the spot rate and the ratio of the interest rates in the two countries whose currencies you are trading.

Many other economic events[3] factor into exchange rates. Just consider the impact of China’s zero-COVID policy on production in China and world supply chains. The ripples from China’s efforts have severely impacted every type of market in the world, including Forex markets.

International Trade and Capital Flows

Trade balances can also drive exchange rates in favor of trading partners with surpluses. High demand for goods from one country, coupled with payment for those goods in the local currency (e.g., paying for U.S. goods in dollars), can drive up the value of the local currency. In contrast, countries that predominantly import goods will have lower currency values than their exporting partners.

But more flows than trade surpluses and deficits work as market drivers. For example, substantial foreign investment in a country can drive currency values up. And internal drivers also exist, particularly when a country’s central bank intervenes to shore up a currency’s value.

There is also the consideration of capital flows in and out of a country.  For example, Japanese companies look to repatriate their profits back to Japan every year around their financial year-end, which leads to seasonal and often predictable strength in the Japanese Yen as these companies sell their foreign currency and buy Yen.

Speculation

Another potential drive of exchange rates is currency speculation itself. If sufficient money flows into a currency pair, that bet on future value can impact the actual future rates. Consider it much the same as sportsbook betting – favorites often increase their point spreads shortly before a game. However, these effects are typically short-term, and other factors tend to be more important in the long run.

Speculators may bet on or against specific flows or specific events, like economic releases or central bank actions. One famous example was Black Wednesday in September 1992, when a hedge fund led by George Soros broke the Bank of England.

Technical Analysis

Technical analysis is a tool, or method, used to predict the probable future price movement of a security – such as currency pairs – based on past market data.

The theory behind the validity of technical analysis is the notion that the collective actions – buying and selling – of all the participants in the market accurately reflect all relevant information pertaining to a traded security and, therefore, continually assign a fair market value to the security.

Technical traders analyze price charts to attempt to predict price movement. The two primary variables for technical analysis are the time frames considered and the particular technical indicators that a trader chooses to utilize.

The technical analysis time frames shown on charts range from one-minute to monthly, or even yearly, time spans.

In foreign exchange, technical analysis is very important to gauge support and resistance levels as the market is so liquid and transparent.

Conclusion

The Forex markets offer investors an interesting, well-capitalized, and highly liquid alternative to traditional equity and debt markets. But to best profit from FX trading, investors need to understand well the various forces that drive exchange rates.

The FX market reacts extremely quickly to short-term external factors, such as economic news and releases, speculative flows, rates arbitrage, and technical levels. These factors tend to be short-lived and generally won’t persist for more than a few trading sessions or days.

In the medium term, International trade flows impact exchange rates as these flows will be a bit longer and consistent over a longer time period of weeks, months, and even years. Examples of the demand or supply of currencies from these sorts of flows would be the balance of imports and exports, direct foreign investment projects in a country, investment flows into a country’s financial markets, and also central bank intervention creating artificial supply or demand for a currency.

More Resources

Thank you for reading CFI’s guide to What Influences Exchange Rates. To keep advancing your career, the additional CFI resources below will be useful:

• Foreign Exchange Fundamentals
• Spot Foreign Exchange
• Economics for Capital Markets
• Trading Using Technical Analysis