How Are Exchange Rates Determined ?

The Foreign exchange market is far more complicated as compared to stock or bond markets. Predicting the foreign exchange rate includes predicting the performance of entire economies. There are a multitude of factors which come into play when exchange rates are being determined. This article lists down and explains some of the important factors which have a major influence on the exchange rates.

Pricing In The Future Expectations

Foreign Exchange markets are also financial markets. The price reflected in any financial market does not reflect the price of today. Rather, it reflects the expectations about the future based on the information that we have on hand today. Therefore, the foremost and important determinant of Forex rates between any two countries is expectations about the future.

The term “expectations about the future” sounds like a vague and generic term. The next question arises, “expectations about what?” The remainder of this article will explain the various factors that influence the exchange rates.

Comparison of Monetary Policy

Exchange rates are basically a comparison between the policies of two countries. It is essential to understand that exchange rates are not absolute rather they are relative. The following factors are considered amidst many others while comparing the monetary policies of any two countries.

• Inflation: Exchange rate is basically a ratio between the expected number of units of one currency and the expected number of units of other currency in the market. Inflation increases the number of currency units. Therefore, if one currency is facing inflation at the rate of 6% whereas the other is only facing inflation at the rate of 2%, then the ratio between the two is bound to change. Hence, inflation rates are a major factor while determining exchange rates. However, the official inflation rates often do not tell the true picture. Therefore, participants of the market use their own estimates of inflation rate and come up with their own valuations for currency pairs.

• Interest Rates: When investors hold a certain currency, they get a yield in terms of the interest rate that is applicable on that currency. Therefore if investors were to hold a currency with a 6% yield as opposed to a 3% yield, they would end up profiting more! Therefore, the interest rate yields are also priced into the Forex rates that are quoted in the market. The currency valuations are extremely subjective to interest rate changes. A small change in this rate brings about a big reaction from the market participants.

Therefore, Central Banks become extremely important participants in the Forex market since they control the monetary policy which is one of the biggest determinants of the value of the currency.

Comparison of Fiscal Policy

While monetary policy is controlled by the Central Bank of the country, the fiscal policy is controlled by the government. This too has important implications because it signals the forthcoming changes in the monetary policy.

• Public Debt: A large amount of public debt means that the government of a country will have to make huge interest payments. Investors will analyze whether these payments can be collected from the tax i.e. from existing money supply. If not, then this signals that the country will monetize its debt i.e. print more currency and pay off the debt. Since a huge public debt today is a signal of problems coming up in the future, the Forex market prices this too in the value that is quoted.

  However, it needs to be understood that once again there is a relative comparison between the public debts of the two countries in question. Absolute amounts may not matter as much!

• Budget Deficit: Another major factor which influences the Forex rates is the budget deficit. This is because a budget deficit is a precursor to public debt. Governments spend more money than they have and as a result run up a budget deficit. This deficit then has to be financed by debt. The problems pertaining to public debt and how it impacts the Forex rate have already been discussed in the above point.

Political Stability

Political stability of the country in question is also of prime importance for Forex rates. This is because modern monetary system is a system of Fiat money. This means that money is nothing except the promise of the government. Therefore, if there is a danger to the government, there is a danger that the promise itself may be worthless once a new government takes over. It is possible that the new government may want to issue a new currency of its own! Therefore, whenever a country faces a geopolitical turmoil, its currency usually takes a beating in the Forex markets.

Speculation and Market Sentiment

Lastly, the Forex market is extremely speculative in nature. This is because Forex provides the leverage for investors to amplify their trade several times using borrowed money and then invest in the markets. Therefore, sentiments take over the Forex market more than they take over other asset markets because of the availability of easy money.

Hence, just like all other markets, Forex markets are prone to irrational exuberance and they too can distort exchange rates in the short term creating long term investment opportunities.

Many other factors like the price of commodities such as gold and oil also play a vital role in the determination of Forex rates. However, that will be discussed in a later article in this module.