Factors That Affect Forex Exchange Rates

Wednesday, May 9, 2012
Whether you’re going to be using fundamental analysis or not in your trading, you’re probably curious about the factors which affect Forex exchange rates. If you’re relatively new to trading, this is a subject you may not be well versed in. The economic factors surrounding Forex are myriad and complex, so you may never have a thorough understanding of them (plenty of successful traders don’t), but the more thorough your understanding is, the more useful knowledge you have at your disposal.

Some of the main factors which affect Forex exchange rates include interest, inflation, trade balance, speculation, foreign investment, and central bank intervention. Interest rates and inflation are interlinked concepts. When inflation is high, central banks in countries may raise the interest rate for borrowing money, which reduces consumer spending in turn. When inflation is low, central banks may drop interest rates to indirectly encourage consumer spending. Currencies that have higher interest rates offer a more substantial return, so oftentimes Forex investors will buy into them and sell currencies with low interest rates to make a profit. Doing this over an extended time period is known as a carry trade.

Balance of trade (a country’s imports vs. that same country’s exports) may also impact the level of demand for its currency. When a country exports more than it imports, that country has a positive trade balance, and there is more demand for that country’s currency on the Forex market.

Speculation from large and small investors may also impact the values of currencies. Traditionally it has been large investors that really move the market (usually not private traders), though retail spot Forex traders now have more of a measurable impact than they used to. Traders speculate based off of many different things including economic reports and news. Similarly, investors often flock to currencies they perceive as «safe.» For a long time that was the US dollar. When confidence in a currency drops, investors sell that currency off. Both actions can impact the value of the currency.

Finally, raising and lower interest rates aren’t the only way in which central banks can intervene with their respective economies and alter the values of currencies. Central banks may also engage in quantitative easing, which is a last resort to resolving economic difficulties if lowering interest rates fails. This is a way in which central banks can increase the liquidity of a country’s banking system. Too much of this and the country’s currency may lose value, which is why it is risky and a last resort.

As you can see, there are many different factors which drive the fluctuating prices on the foreign exchange market. To actually trade fundamentals involves a tremendous amount of research; even among professional economists there is a great deal of disagreement as to how things really work. Nonetheless, trading fundamentals does work well for some Forex traders. Whatever you choose to do, do thorough backtests and demo tests before you trade with real money. Never speculate wildly-have a method in place for your decisions.