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How Foreign Exchange Rates Are Set
As a forex traders, while you will not need more than a very basic underlay of knowledge on the internal workings of the fx system, it’s useful to understand how foreign exchange rates are set, and what might influence them.
Fx rates are the value of one currency when compared to another currency. The given rate will determine how much of one currency you can get when you try and exchange it for another. So, when you go on holiday to Spain, you may want to exchange some of your Pound Sterling for Euros. You might see a rate such as 1.100 – this means that for every pound, you can get 1.1 Euros in exchange.
How are rates set? In free market economies, the day to day fx rates are set and determined by the underlying forces of supply and demand. While this is basic and logical economics, the actual rate setting process will depend on a flurry of highly fluid and continually changing factors and circumstances. The economy, several government policies and even freak world events can cause seismic rate fluctuations. Forex traders thrive on these movements as it allows them to profit from the price volatility.
One of the best ways of understanding how the rates of a currency pair might be set and will fluctuate, is to analyze the underlying demand and supply of the two currencies involved. While the basic forces of supply and demand apply in the fx universe, it’s somewhat harder to analyze and predict how they might influence a currency pair. Typically, when the demand for a currency rises relative to the demand of the other currency, it’s exchange rate will strengthen against that currency. At a very basic level, if more people want Pounds than Dollars – the Pound will strengthen against the dollar.
How the demand for currencies is shaped – When demand for a country’s goods, services or investments that must be purchased using its domestic currency rises – it effectively raises the demand for that currency in tow. Government policy can be influential in such cases – for example, if the UK government drops the corporation tax rate like a stone, the effect will be to attract foreign companies to set up their businesses in the country – they would need British Pounds to do so, thus raising the demand for the UK Pound (GBP). If at the same time, if the US government doubles its corporation tax rates, many companies currently in the USA might decide to set up shop in the UK instead. There would be a likely sell off in the USD in exchange for the Pound. What would happen to the pound against the dollar? It would rise.
How the supply of currencies can change – Governments can print and pump more currency into an economy and increase the supply in circulation. Post the financial crisis, this process has been dubbed as “Quantitative Easing”. Inflating a currency by printing acts to devalue the currency against other currencies who are not doing the same.
Finally – Foreign Exchange Rates Are Very Relative
Remember that foreign exchange rates are very relative – so all factors we’ve discussed above must be compared and contrasted for both currency pairs. That’s often what makes predicting foreign exchange rates so tricky.