The foreign exchange market is the market to determine the price of different currencies in terms of one another in order to enable trade between countries and to provide a ways to transfer currency associated risks arising from economic transactions.
Determinants of Exchange Rates:
The foreign exchange rates constantly responds to a number of economic valuables, both domestic and global, which have an impact on the demand and supply of foreign currency in the short term and long terms. Some of the factors that affect the value of a currency in the foreign exchange market include the Gross Domestic Product (GDP) growth rate, balance of payment situation, deficit situation, inflation, interest rate scenario, policies related to inflow and outflow of foreign capital. It is also a function of factors like prices of crude oil, value of against other currency pairs and geopolitical situation.
1. Differentials in Inflation:
A country with a consistently lower inflation rate exhibits rising currency value, as its purchasing power increases relative to other currencies. During the last half of the 20th Century, the counties 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.
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. Th impact of higher interest rates is mitigated, however, if inflation int he country is much higher than in others, or if additional factors serve to drive the currency down.
3. Current Account Deficit:
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.
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 larger debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in future.
5. Terms of trade:
A ratio comparing export prices to import prices, the terms of trade is related to current accounts and 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.
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 can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.
The exchange rate of the currency in which a portfolio holds the bulk of its investment determines that portfolio' real 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 economist, investors should still have some understanding of how currency values and change rates play an important role in the rate of return on their investments.
Determinants of Exchange Rates:
The foreign exchange rates constantly responds to a number of economic valuables, both domestic and global, which have an impact on the demand and supply of foreign currency in the short term and long terms. Some of the factors that affect the value of a currency in the foreign exchange market include the Gross Domestic Product (GDP) growth rate, balance of payment situation, deficit situation, inflation, interest rate scenario, policies related to inflow and outflow of foreign capital. It is also a function of factors like prices of crude oil, value of against other currency pairs and geopolitical situation.
1. Differentials in Inflation:
A country with a consistently lower inflation rate exhibits rising currency value, as its purchasing power increases relative to other currencies. During the last half of the 20th Century, the counties 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.
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. Th impact of higher interest rates is mitigated, however, if inflation int he country is much higher than in others, or if additional factors serve to drive the currency down.
3. Current Account Deficit:
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.
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 larger debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in future.
5. Terms of trade:
A ratio comparing export prices to import prices, the terms of trade is related to current accounts and 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.
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 can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.
The exchange rate of the currency in which a portfolio holds the bulk of its investment determines that portfolio' real 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 economist, investors should still have some understanding of how currency values and change rates play an important role in the rate of return on their investments.
Presentation and explanation of all relevant point is nice. If you can explain by an example then it will be more beneficial.
ReplyDeleteA person based invest $1000 in a bank deposit @10% for 1 year when the exchange rate is 45 per US $. After 1 year, the currency depreciate and the exchange rate is 50 per US $. What is the risk of his investment if he decides to repatriate the money back?
DeleteSolution: Investment amount = US$ 1000 x 45 = 45,000
Interest earned = 45000 x 10% = 4500
value after 1 year = 45000 + 4500 = 49500
value after 1 year in US $ = 49500 / 50 = $ 990
Loss in investment = $1000-$990 = $10
The deposit paid a nominal return of 10%, there was a loss in investment value, because the exchange rates depreciated by more than 10%.
A quote of EURINR 76.7652 read as a price of INR 76.7652 for one EURO. The first currency is called "Base currency" and the second one is "Quotation currency". Euro is the base currency and INR is the quotation currency.
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