Factors Affecting Exchange Rates in Forex Trading

Beside inflation and interest rates, exchange rate is one of the most important factors that help to know the economic health of a country. In Forex trading exchange of currencies takes place. Actual exchange rate can be determined by the demand and supply of the corresponding currencies. Demand of one currency is directly connected to the supply of another currency. Currency exchange rates also affect the real return on an investor’s portfolio. Below are some of the main forces that are responsible for the movements of exchange rates

Difference in inflation of two countries
 

It is a very general rule that a country having lower inflation rates has higher currency value and greater purchasing power relative to other currencies.

 

Difference in interest rates in Forex trading
 

Exchange rates are highly correlated with the interest rates and inflation. Higher interest rates cause the exchange rates to rise by attracting foreign capital. On the other hand lower interest rates tend to reduce exchange rates. When the interest rate of one country rises or falls in comparison to another country; the currency of the country with low interest rate will be sold whereas the currency of the country with higher interest rates will be bought so as to gain higher returns.

Let us take an example to know the influence of interest rates on currency trading exchange rates. Suppose two countries X and Y do not use foreign exchange control and money can flow freely between these two countries. Suppose country X raises its interest rate by 1% but the interest rate of country Y remains unchanged. A large part of the capital from country Y will flow into the country X. A large amount of country Y’s currency will be exchanged for country X’s currency. This increased demand of country X’s currency will strengthen it against country Y’s currency.

Monetary policy
 

Participation of the central bank in Forex trading influences the exchange rates. Usually, central bank participates in foreign exchange market by buying or selling the home currency in order to stabilize the market at a level that is realistic. Prediction by the market players on the future policy will also affect the exchange rates.

Political conditions
 

Growing political problems will result in the volatility in the Forex trading market which ultimately causes significant fluctuations in exchange rates. The stability of the currency of a country is directly related to the political condition of that country. In short, the currency of any country is stable if the political conditions of that country are stable.

Market Judgment
 

The online trading market never follows a logical pattern of change. Exchange rates are affected by various factors such as emotions as well as economic and political events. Market operators should provide reports and data including inflation indicators, balance of payments, economic growth rates etc. But before these data and reports become available to the common people, the market would have already made its own judgment and predictions and they are reflected in the prices of the currencies and if the actual reports and data move away too much from the judgment and predictions of the market, great fluctuations in the exchange rates take place. Exact understanding of the reports and data is not sufficient; a good Forex trading individual should understand the market reactions before the information becomes available for the public.