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.
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.
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.
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.