6 Factors that Influence Exchange Rates

What is Currency Exchange Rates?

$1=₹74

Isn’t this the most common conversion we all have seen?

This conversion tells us that the worth of 1 U.S. dollar is equivalent to 74 Indian Rupees.

But where did this conversion come from? How do we arrive at this?

Read on to find out.

Well firstly, we see the U.S. dollar, the euro, and the yen most often because they are among the strongest currencies. These currencies are the ones most widely used around the globe for international trade and transactions. The U.S dollar is considered the standard currency for the trade of a lot of commodities internationally.

The exchange rates are also of significance for foreign exchange trading. Foreign exchange trading, also known as forex trading, is the trading of currencies. An example of how it works is that one can swap rupees for euros or vice versa.

The forex market is the largest, most liquid market present. It has trillions of dollars worth of transactions happening every day. It has no location and is an electronic network consisting of many entities that are involved or required in the transactions that are placed in the foreign exchange market.

Exchange rates are always listed in pairs. For example, USD/INR represents the U.S. dollar vs Indian rupees.

These pairs also have a price associated with them.

For the sake of an example let’s say the price is 1.5 and the pair is ABC/XYZ.

This means that it costs 1.5 XYZ to buy one ABC.

Here Are The Factors That Influence Exchange Rates:

1. Inflation

Inflation is the rise in the price level of an economy over a certain period. Inflation is said to have an inverse relation with the strength of the currency. The lesser the inflation, the stronger the currency. Increased inflation is caused by the increase in the prices of goods, with no or relatively lower increase in the purchasing power, among many other reasons.

2. Interest Rates

While interest rates are considered a factor of its own, it is highly correlated to inflation. Countries’ central banks use interest rates to control the inflation in a country. The higher the interest rates, the more it attracts foreign investors, which further bolsters its currency rates.

But if inflation also stays high for too long, the high-interest rates can’t hold the currency. And it ultimately leads to currency devaluation.   

3. Current account deficit

What this simply means is that there is a deficit in the current account of the country or it is spending more money on foreign trade than it is earning. This is generally accompanied by borrowing capital from foreign entities to fill up the deficit.

The increased demand for foreign goods (or currency) reduces the exchange rate.

4. Public debt

Public debt again is correlated to inflation. Here&rsquo's how. Public debt is the borrowing of the government to fulfill projects or other related functions. The more the debt, the higher the chance of inflation. Countries with large public deficits or debts are not as attractive to foreign investors. This is because inflation results in a threat to the returns of foreign investors since the exchange rate weakens with increasing inflation.

5. Political stability and economic performance

This one is more intuitive. Political stability and economic performance is reviewed by investors before investing in a country. Naturally, the better these factors, the more attractive a country becomes in terms of foreign investing. These factors can either cause a gain or loss in confidence of foreign investors towards investments in a country.

6. Speculation

Traders also study the expected change of the strength of currencies before trading in it. The demand of a country’s currency increases if the value of it is expected to go up. This enables investors to make a profit in the future. Due to this speculation of an increase in value of the currency, the demand for it increases. This results in increasing the exchange rate as well.

 These are some of the important and prominent factors that affect the exchange rate of a country.

Key Takeaways:

1. Exchange rates is a rough indicator to the overall economic strength of the country.
2. The strongest currencies of the world are taken to be the standard currency for international trade.
3. A high interest rate can increase the currency value in the short term, but it may not sustain due to a high inflation environment.

Disclaimer:

ICICI Securities Ltd.(I-Sec). Registered office of I-Sec is at ICICI Securities Ltd. - ICICI Centre, H. T. Parekh Marg, Churchgate, Mumbai - 400020, India, Tel No : 022 - 2288 2460, 022 - 2288 2470. The contents herein above shall not be considered as an invitation or persuasion to trade or invest. Investments in securities market are subject to market risks, read all the related documents carefully before investing. I-Sec and affiliates accept no liabilities for any loss or damage of any kind arising out of any actions taken in reliance thereon. The securities quoted are exemplary and are not recommendatory. The contents are solely for informational and educational purpose.