Understanding the Factors that Affect Forex Trading Rates
Foreign exchange is one of the largest financial markets in the world. On a daily basis, its average turnover is approximately valued at more than $3,000 billion (or $3 trillion). This is due to the high liquidity of foreign exchange and the geographically dispersed characteristic of the market. Like any market, where buying and selling of goods and services occur, the forex market enables the buying and selling of currency (goods) and trading tools (services). Unlike a regular market, however, foreign exchange operates virtually via telecommunications networks. Today, banking systems provide online platforms, which provide investors access to currency markets.
Before participating in forex trading activities, a crucial step that you should take is to study the market first. Determine the factors affecting the market environment and understand how these factors interact. These interactions are what influences forex trading rates and shape the market itself.
Let’s say that you want to plant a garden with vegetables, fruit trees, and flowers in it. Of course, your choice of plants and trees will be limited by inherent factors, such as access to water and sunlight, quality of the soil, and climate conditions in your area, as well as by external factors, such as your neighbor’s pets. After considering these things, you select only the type of vegetation that would thrive in your garden. Especially if you have to buy the seedlings, you decide that paying for those that have very low chances of surviving the conditions in your backyard is unwise. Then, you choose when the right time for planting is. The same practices apply to currency trading.
Forex trading 101
As a virtual market, forex is an interconnected but decentralized system where various currencies are traded. It means that the price of a currency, such as a US dollar, may vary from place to place. Banks all over the globe engage in forex trading activities, although the main trading centers are found in London (United Kingdom), New York (United States), and Tokyo (Japan). Trading sessions do not occur simultaneously. The US session starts toward the end of the European session, which starts when the Asian session ends. At the end of the US trading session, the cycle returns to the Asian market. Hence, market participants can make decisions as soon as they get the latest information without having to wait for the market to open.
The rise and fall of exchange rates may be attributed both to actual monetary flows and anticipated adjustments in these flows. These are likewise influenced by fluctuations in GDP (gross domestic product) growth, inflation, interest rates, budget and trade deficits and surpluses, and other factors. Success in forex trading, therefore, is based on perception and the ability to read between the news lines.
Why does forex cause all this fuss? Each country has its currency, and if you want to buy products or use services from a particular country, you need to pay in their local currency. For instance, if you want an exquisite Maori carving from New Zealand, you must pay in NZD (New Zealand dollar), since Maori artists buy their materials and tools in New Zealand.
With globalization and the Internet, several transactions happen across countries within a short period. Customers are willing to shell out more as the supply of products goes lower. Hence, a free-floating currency system exists to allow countries to trade currencies depending on trade values and interests. In forex trading, if you are a holder of a currency, such as the US dollar, you get interest on that currency. When the interest to the US dollar increases, the US dollar becomes more desirable.
However, we did not always have the free-floating currency system. Countries used to pay for each other’s goods and services with gold and silver. The problem with this practice is that external supply and demand influenced the value of the medium of exchange. This means that as more gold mines and silver quarries are found, the value of gold and silver are driven down. Hence, the gold standard monetary system was established in 1875. The core concept of this system was that each country’s government ensured the conversion of its currency into a particular amount of gold. A country would have to hold a sufficient amount of gold to fulfill the demand for currency exchanges. The price differences for an ounce of gold between two different currencies were their exchange rates.
At the start of World War I, the system collapsed. Countries had to spend more on military expenditures, so their gold reserve was insufficient for backing the money being printed. The Bretton Woods Agreement established in 1944 was somewhat a comeback of the gold standard system. Currencies were tied to the US dollar, the value of which was fixed at $35 to an ounce of gold. Since only the US dollar was backed by gold, the US began to run out of gold reserves to support US dollars held in various countries. US President Richard Nixon’s announcement to stop the exchange of gold for US dollars in the 1970s signified the demise of the Bretton Woods system. Since then, floating forex rates have applied, although governments use strategies, such as dollarization and pegged rates, to protect the value of their currencies, which float against each other– solely dependent on the market’s “invisible hand.”
Factors that affect forex trading rates
Fluctuations in exchange rates between two currencies occur as their value changes. For instance, if the demand for the US dollar is higher than its supply, its value increases. When the demand is lower than the supply, the dollar’s value declines, as traders would rather hold currencies with higher values and interests.
There are fundamental, political and psychological, technical, and speculative factors influencing forex rates. Fundamental and technical factors include monetary and fiscal policies that governments make concerning the balance of payment, capital utilization, export and import, inflation, unemployment, and other aspects relevant to economic growth. When a country’s business activity and employment levels are high, the transaction demand for its currency increases because people can afford to buy more products.
On a more speculative aspect, a central bank may adjust the interest rate since an investor would want to obtain currencies with higher returns (or interest rates). Hence, countries with higher interest rates expect the demand for their currencies to be high as well. Political and psychological factors, such as a political crisis or unstable social climates, are said to have adverse effects on forex rates.
How to deal with the negative effects of these factors
If you engage in international transactions regularly, you would want to protect your investment or reduce the risks brought about by forex market fluctuations. This is called currency hedging. Common hedge tools include spot contracts and forward transactions, among other instruments provided by banks and financial services. Spot contracts allow you to convert your currency into dollars or pay in any foreign currency at the current exchange rate, although settlement will be made days later. Forward transactions make it possible for you to buy or sell a currency at a pegged rate even if the payment will be made on a future date. Other methods derived from these include window forwards, use of options, and currency swaps.