Factors Influencing Exchange Rates

What is Exchange rate:

In finance, an exchange rate (also known as a foreign-exchange rate, forex rate, FX rate or
Agio) between two currencies is the rate at which one currency will be exchanged for another. It
is also regarded as the value of one countrys currency in terms of another currency. [1] For
example, an interbank exchange rate of 91 Japanese yen (JPY, ) to the United States dollar
(US$) means that 91 will be exchanged for each US$1 or that US$1 will be exchanged for each
91. Exchange rates are determined in the foreign exchange market,[2] which is open to a wide
range of different types of buyers and sellers
Definition
Rate at which one currency may be converted into another. The exchange
rate is used when simply converting one currency to another (such as for the
purposes of travel to another country), or for engaging in speculation or
trading in the foreign exchange market. There are a wide variety of factors
which influence the exchange rate, such as interest rates, inflation, and the
state of politics and the economy in each country. also called rate of
exchange or foreign exchange rate or currency exchange rate.

Most governments today use one of the following three exchange rate
systems:

Dollarization

Pegged rate

Managed floating rate

Dollarization
Dollarization occurs when a country decides not to issue its own currency and uses
a foreign currency as its national currency. Although dollarization usually allows a
country to be seen as a more stable place for investment, the downside is that the
country's central bank can no longer print money or control the country's monetary
policy. One example of dollarization is El Salvador's use of the U.S. dollar. (To read
more, see Dollarization Explained.)

Pegged Rate
Pegging is when one country directly fixes its exchange rate to a foreign currency so
that the country will have somewhat more stability than a normal float. More
specifically, pegging allows a country's currency to be exchanged at a fixed rate.
The

currency

will

only

fluctuate

when

the

pegged

currencies

change.

For example, China pegged its yuan to the U.S. dollar at a rate of 8.28 yuan to
US$1, between 1997 and July 21, 2005. The downside to pegging is that a
currency's value is at the mercy of the pegged currency's economic situation. For
example, if the U.S. dollar appreciates substantially against all other currencies, the
Chinese yuan will also appreciate, which may not be what the Chinese central bank
wants, since China relies heavily on its low-cost exports.
Managed Floating Rates:
This type of system is created when a currency's exchange rate is allowed to freely
fluctuate subject to supply and demand. However, the government or central bank
may intervene to stabilize extreme fluctuations in exchange rates. For example, if a
country's currency is depreciating very quickly, the government may raise shortterm interest rates. Raising rates should cause the currency to appreciate slightly;
but understand that this is a very simplified example. Central banks can typically
employ a number of tools to manage currency.

Definition of 'Exchange Rate'

The price of a nations currency in terms of another currency. An exchange rate thus
has two components, the domestic currency and a foreign currency, and can be
quoted either directly or indirectly. In a direct quotation, the price of a unit of foreign
currency is expressed in terms of the domestic currency. In an indirect quotation,
the price of a unit of domestic currency is expressed in terms of the foreign
currency. An exchange rate that does not have the domestic currency as one of the
two currency components is known as a cross currency, or cross rate.
Also known as a currency quotation, the foreign exchange rate or forex rate.
An exchange rate has a base currency and a counter currency. In a direct quotation,
the foreign currency is the base currency and the domestic currency is the counter
currency. In an indirect quotation, the domestic currency is the base currency and
the

foreign

currency

is

the

counter

currency.

Most exchange rates use the US dollar as the base currency and other currencies as
the counter currency. However, there are a few exceptions to this rule, such as the
euro and Commonwealth currencies like the British pound, Australian dollar and
New

Zealand

dollar.

Exchange rates for most major currencies are generally expressed to four places
after the decimal, except for currency quotations involving the Japanese yen, which
are quoted to two places after the decimal.
Lets consider some examples of exchange rates to enhance understanding of these
concepts.

US$1 = C$1.1050. Here the base currency is the US dollar and the counter currency is the
Canadian dollar. In Canada, this exchange rate would comprise a direct quotation of the
Canadian dollar. This is easy to understand intuitively, since prices of goods and services

in Canada are expressed in Canadian dollars; therefore the price of a US dollar in

Canadian dollars is an example of a direct quotation for a Canadian resident.

C$1 = US$ 0.9050 = 90.50 US cents. Here, since the base currency is the Canadian dollar
and the counter currency is the US dollar, this would be an indirect quotation of the
Canadian dollar in Canada.

If US$1 = JPY 105, and US$1 = C$1.1050, it follows that C$1.1050 = JPY 105, or C$1 =
JPY 95.02. For an investor based in Europe, the Canadian dollar to yen exchange rate
constitutes a cross currency rate, since neither currency is the domestic currency.

Exchange rates can be floating or fixed. While floating exchange rates in which currency rates
are determined by market force are the norm for most major nations, some nations prefer to fix
or peg their domestic currencies to a widely accepted currency like the US dollar.
Exchange rates can also be categorized as the spot rate which is the current rate or a forward
rate, which is the spot rate adjusted for interest rate differentials.

Six Factors That Influence Exchange Rates

Aside from factors such as interest rates and inflation, the exchange rate is one of the most
important determinants of a country's relative level of economic health. Exchange rates play a
vital role in a country's level of trade, which is critical to most every free market economy in the
world. For this reason, exchange rates are among the most watched, analyzed and
governmentally manipulated economic measures. But exchange rates matter on a smaller scale as
well: they impact the real return of an investor's portfolio. Here we look at some of the major
forces behind exchange rate moments.
Overview
Before we look at these forces, we should sketch out how exchange rate movements affect a
nation's trading relationships with other nations. A higher currency makes a country's exports
more expensive and imports cheaper in foreign markets; a lower currency makes a country's

exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can
be expected to lower the country's balance of trade, while a lower exchange rate would increase
it.
Determinants in Exchange Rates
Numerous factors determine exchange rates, and all are related to the trading relationship
between two countries. Remember, exchange rates are relative, and are expressed as a
comparison of the currencies of two countries. The following are some of the principal
determinants of the exchange rate between two countries. Note that these factors are in no
particular order; like many aspects of economics, the relative importance of these factors is
subject to much debate.
1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a rising currency
value, as its purchasing power increases relative to other currencies. During the last half of the
twentieth century, the countries with low inflation included Japan, Germany and Switzerland,
while the U.S. and Canada achieved low inflation only later. Those countries with higher
inflation typically see depreciation in their currency in relation to the currencies of their trading
partners. This is also usually accompanied by higher interest rates. (To learn more, see CostPush Inflation Versus Demand-Pull Inflation.)
2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest
rates, central banks exert influence over both inflation and exchange rates, and changing interest
rates impact inflation and currency values. Higher interest rates offer lenders in an economy a
higher return relative to other countries. Therefore, higher interest rates attract foreign capital and
cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if
inflation in the country is much higher than in others, or if additional factors serve to drive the
currency down. The opposite relationship exists for decreasing interest rates - that is, lower
interest rates tend to decrease exchange rates. (For further reading, see What Is Fiscal Policy?)

3. Current-Account Deficits
The current account is the balance of trade between a country and its trading partners, reflecting
all payments between countries for goods, services, interest and dividends. A deficit in the
current account shows the country is spending more on foreign trade than it is earning, and that it
is borrowing capital from foreign sources to make up the deficit. In other words, the country
requires more foreign currency than it receives through sales of exports, and it supplies more of
its own currency than foreigners demand for its products. The excess demand for foreign
currency lowers the country's exchange rate until domestic goods and services are cheap enough
for foreigners, and foreign assets are too expensive to generate sales for domestic interests. (For
more, see Understanding The Current Account In The Balance Of Payments.)
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects and
governmental funding. While such activity stimulates the domestic economy, nations with large
public deficits and debts are less attractive to foreign investors. The reason? A large debt
encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off
with cheaper real dollars in the future.
In the worst case scenario, a government may print money to pay part of a large debt, but
increasing the money supply inevitably causes inflation. Moreover, if a government is not able to
service its deficit through domestic means (selling domestic bonds, increasing the money
supply), then it must increase the supply of securities for sale to foreigners, thereby lowering
their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country
risks defaulting on its obligations. Foreigners will be less willing to own securities denominated
in that currency if the risk of default is great. For this reason, the country's debt rating (as
determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its
exchange rate.

5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current accounts
and the balance of payments. If the price of a country's exports rises by a greater rate than that of
its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater
demand for the country's exports. This, in turn, results in rising revenues from exports, which
provides increased demand for the country's currency (and an increase in the currency's value). If
the price of exports rises by a smaller rate than that of its imports, the currency's value will
decrease in relation to its trading partners.
6. Political Stability and Economic Performance
Foreign investors inevitably seek out stable countries with strong economic performance in
which to invest their capital. A country with such positive attributes will draw investment funds
away from other countries perceived to have more political and economic risk. Political turmoil,
for example, can cause a loss of confidence in a currency and a movement of capital to the
currencies of more stable countries.

Exchange Rate Dynamics & Currency Factors:

Currency changes affect you, whether you are actively trading in the foreign exchange market,
planning your next vacation, shopping online for goods from another countryor just buying
food and staples imported from abroad.
Like any commodity, the value of a currency rises and falls in response to the forces of supply
and demand. Everyone needs to spend, and consumer spending directly affects the money supply
(and vice versa). The supply and demand of a countrys money is reflected in its foreign
exchange rate.

When a countrys economy falters, consumer spending declines and trading sentiment for its
currency turns sour, leading to a decline in that countrys currency against other currencies with
stronger economies. On the other hand, a booming economy will lift the value of its currency, if
there is no government intervention to restrain it.
Consumer spending is influenced by a number of factors: the price of goods and services
(inflation), employment, interest rates, government initiatives, and so on. Here are some
economic factors you can follow to identify economic trends and their effect on currencies.

1. Interest Rates
Benchmark" interest rates from central banks influence the retail rates financial institutions
charge customers to borrow money. For instance, if the economy is under-performing, central
banks may lower interest rates to make it cheaper to borrow; this often boosts consumer
spending, which may help expand the economy. To slow the rate of inflation in an overheated
economy, central banks raise the benchmark so borrowing is more expensive.
Interest rates are of particular concern to investors seeking a balance between yield returns and
safety of funds. When interest rates go up, so do yields for assets denominated in that currency;
this leads to increased demand by investors and causes an increase in the value of the currency in
question. If interest rates go down, this may lead to a flight from that currency to another.

2. Employment Outlook
Employment levels have an immediate impact on economic growth. As unemployment increases,
consumer spending falls because jobless workers have less money to spend on non-essentials.
Those still employed worry for the future and also tend to reduce spending and save more of
their income.
An increase in unemployment signals a slowdown in the economy and possible devaluation of a
country's currency because of declining confidence and lower demand. If demand continues to
decline, the currency supply builds and further exchange rate depreciation is likely. One of the
most anticipated employment reports is the U.S. Non-Farm Payroll (NFP), a reliable indicator of
U.S. employment issued the first Friday of every month.

3. Economic Growth Expectations

To meet the needs of a growing population, an economy must expand. However, if growth occurs
too rapidly, price increases will outpace wage advances so that even if workers earn more on
average, their actual buying power decreases. Most countries target economic growth at a rate of
about 2% per year. With higher growth comes higher inflation, and in this situation central banks
typically raise interest rates to increase the cost of borrowing in an attempt to slow spending
within the economy. A change in interest rates may signal a change in currency rates.
Deflation is the opposite of inflation; it occurs during times of recession and is a sign of
economic stagnation. Central banks often lower interest rates to boost consumer spending in
hopes of reversing this trend.
4. Trade Balance
A country's balance of trade is the total value of its exports, minus the total value of its imports.
If this number is positive, the country is said to have a favorable balance of trade. If the
difference is negative, the country has a trade gap, or trade deficit.
Trade balance impacts supply and demand for a currency. When a country has a trade surplus,
demand for its currency increases because foreign buyers must exchange more of their home
currency in order to buy its goods. A trade deficit, on the other hand, increases the supply of a
countrys currency and could lead to devaluation if supply greatly exceeds demand.

5. Central Bank Actions

With interest rates in several major economies already very low (and set to stay that way for the
time being), central bank and government officials are now resorting to other, less commonly
used measures to directly intervene in the market and influence economic growth.
For example, quantitative easing is being used to increase the money supply within an economy.
It involves the purchase of government bonds and other assets from financial institutions to
provide the banking system with additional liquidity. Quantitative easing is considered a last
resort when the more typical responselowering interest ratesfails to boost the economy. It

comes with some risk: increasing the supply of a currency could result in a devaluation of the
currency.
Conclusion
The exchange rate of the currency in which a portfolio holds the bulk of its investments
determines that portfolio's real return. A declining exchange rate obviously decreases the
purchasing power of income and capital gains derived from any returns. Moreover, the exchange
rate influences other income factors such as interest rates, inflation and even capital gains from
domestic securities. While exchange rates are determined by numerous complex factors that
often leave even the most experienced economists flummoxed, investors should still have some
understanding of how currency values and exchange rates play an important role in the rate of
return on their investments.