Determinants in Foreign Exchange Rate
Internationalization of businesses has long since begun when companies through stiff competition looked for new markets and cheap materials and labor. And so to today a global foreign exchange market is not something new. Money is easily transferred from investors and borrower and buyers and sellers even across borders.
And since different countries use different currencies, money has to be converted. Conversion occurs when there is foreign currency exchange. The place where exchange of currency happens is called the foreign exchange market. On how much this currency equals to another is decided by the foreign exchange rate. The date on which two foreign currencies are exchanged is called a settlement date.
Foreign exchange is the largest market in the world. To put that statement in perspective, the sum total of physical goods traded globally in one year's time can be equivalent to a few days' transactions in the foreign exchange market even if you combine the stock markets of Tokyo and New York. The foreign exchange market at USD $1.4 trillion a day is much bigger.
And just how is foreign exchange rate determined? There are three factors that affect foreign exchange rate: supply and demand for money, government intervention and inflation.
For supply and demand of money: the more people want a certain currency the higher the foreign exchange rate will be of such currency. One time in 1988, currency investors got a hint the US dollars had bottomed against the Swiss Francs and is now ready for a rise. These investors rushed to the foreign exchange market to bid more and more in Francs to get the dollar they think will soon worth a high price in Francs. The ending was that the Franc fell and the dollar rose higher than expected.
Foreign currency trading could also be affected by government intervention. The government exerts its influence on foreign exchange rate through actions of the central bank. Reducing the money circulated results to higher foreign exchange rate. More money in circulation on the other hand decreases foreign exchange rate. If foreign exchange rate is high, it becomes expensive to borrow money and so a project funded by borrowing becomes less lucrative for higher returns are expected to cover funding. Lower exchange rate, on the other hand, encourages greater economic activity.
Foreign exchange is also affected by the rate of inflation. The faster prices rise, the lesser is the value of money. Traders watch the development of inflation closely because inflation is said to erode the value of money. If $20 can buy two pairs of running shoes four years ago, by inflation it is possible that only a pair of shoes can be bought at present time.
When you see on TV that USD 1 is equivalent to a certain value of another country's currency, remember that that rate settled that way because of government intervention, supply and demand of money and inflation. There might be other factors affecting foreign exchange rate but these are the main ones.