Understanding How Foreign Exchange Rates Work

Posted by admin 11/02/2014 Comments are off 1185 views

How Foreign Exchange Rates Work

This article explains how various factors influence foreign exchange rates and currency values in the forex market.

The foreign exchange market is currently the biggest financial market in the world in terms of amounts changing hand on a daily basis. Daily trading sees the equivalent of over four trillion U.S. dollars being exchanged. The forex market is also the most liquid, giving traders numerous opportunities to make profits within a very short time. Forex trading involves the buying and selling of currencies based on foreign exchange rates. Currencies from all over the world are listed for trading in the foreign exchange market and they all have different values based on their perceived strength. These values keep fluctuating as the market responds to various factors.

When buying or selling a currency in the foreign exchange market, it means swapping it for a different currency based on the proportionality of their respective values. This proportionality is represented by foreign exchange rates, which are used to determine how two currencies are supposed to be exchanged. Since currency values fluctuate constantly, forex rates also change when this happens. Forex traders have to keep a keen eye on the foreign exchange rates so that they know when to make trading moves that will see them make profits or avoid losses.

Much of forex trading is about speculation but us not entirely guesswork. Forex traders speculate on currency prices based on analysis of various sets of data and their interpretation of market indicators. For example, analyzing the changes in foreign exchange rates over a period of a day, week or month can indicate a certain trend. If the trend shows that the value of a certain currency is rising, traders will buy that currency with the hope of selling it at a much higher price later. If the trend shows a decline in the value of a currency, traders holding that currency will seek to offload it by selling it in the market.

Factors affecting foreign exchange rates

As forex traders closely monitor foreign exchange rates to determine how they trade, they must also seek to understand what causes the changes in the rates. There are several factors that influence the values of currencies in the foreign exchange market and subsequently the foreign exchange rates. Most of these factors are related to the economy and international trade. By understanding how these factors influence currency prices, you will be able to know how the exchange rate is going to react when something related happens. This way, you can make your trading moves early enough to capitalize on good trades or to avoid bad trades.

The economy of a country will have a huge bearing on the value of its currency in the foreign exchange market. For example, a country with a budget surplus will see the value of its currency rise in the forex market since investors see it as a strong currency. If the country has a budget deficit, its currency will be undesirable in the market and its value will fall. The same applies to trade balances, with a trade surplus boosting the value of the currency while a trade deficit weakens it. The foreign exchange rates will change accordingly to reflect these.

Economic indicators like inflation and interest rates also have a strong influence on currency values and foreign exchange rates. High inflation rates mean that a country’s currency has diminished purchasing power. Such a currency will not attract investors in the forex market. Governments often intervene to curb rising inflation by raising interest rates and this also gives a boost to the country’s currency in the forex market.  There will be high demand for the country’s currency coupled with low supply and this will drive the currency value upwards.



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