What Factors Go Into Determining International Exchange Rates?

International currency exchange rates show how much one unit of one currency can be worth in another. Currency exchange rates can either be floating, in which case they fluctuate constantly based on a variety of circumstances, or pegged (or fixed) to another currency, in which case they float but move in lockstep with the pegged currency. Investors can examine assets priced in foreign dollars by knowing the value of their native currency with respect to various foreign currencies. Knowing the dollar to the euro exchange rate, for example, is useful when choosing European assets for a US investor. A falling US dollar may raise the value of overseas investments, whereas a strengthening US currency may decrease the value of international investments. 

Floating and Fixed Exchange rates

A floating rate or a fixed rate are the two basic methods for determining currency pricing. The open market determines a floating rate based on supply and demand in global currency exchanges. As a result, if there is a great demand for the money, its value will rise. If demand is low, the price of that currency will fall. Of course, a number of technical and basic variables will influence what individuals consider to be a fair exchange rate, causing supply and demand to shift correspondingly. Following the fall of the Bretton Woods system between 1968 and 1973, most of the world’s major economies’ currencies were permitted to float freely. 4 As a result, most exchange rates are established by ongoing trading activity in the world’s currency markets rather than being fixed. 

Forex and Commodities

The greater the link between the national currency and the sector’s commodity prices, the more dependent a country is on the key domestic industry. There is no universal rule for identifying which commodities a specific currency is connected with and how strong that link is. Some currencies, on the other hand, are good instances of commodity-forex connections.

Consider the fact that the value of the Canadian dollar is inversely proportional to the price of oil. As a result, the Canadian dollar tends to strengthen versus other major currencies as the price of oil rises. This is due to the fact that Canada is a net oil exporter; when oil prices are high, Canada’s oil export profits increase, providing the Canadian dollar a boost foreign exchange market. The Australian currency, which is strongly associated with gold, is another notable example. Because Australia is one of the world’s largest gold producers, its currency tends to fluctuate in lockstep with gold bullion prices. As a result, if gold prices rise sharply, the Australian dollar is likely to strengthen versus other major currencies.

What Factors affect the exchange rate?

The market dynamics of supply and demand determine floating rates. A currency’s value in respect to another currency is determined by how much demand there is in ratio to supply. For example, if European demand for US dollars rises, the supply-demand connection will lead the price of the US dollar to rise. The market dynamics of supply and demand determine floating rates. A currency’s value in respect to another currency is also analyzed and observed by a list of online Forex brokers and how much demand there is in ratio to supply, as this information plays an important role in company-client relations. If European demand for US dollars rises, for example, the supply-demand connection will lead the price of the US dollar to rise in comparison to the euro.

Interest rate changes, unemployment rates, inflation statistics, gross domestic product estimates, manufacturing statistics, and commodities are just a few of the many geopolitical and economic pronouncements that impact exchange rates across nations. The government, through its central bank, determines a fixed or pegged rate. The rate is determined by comparing it to another major foreign currency. The government will purchase and sell its own currency against the currency to which it is tied to preserve its exchange rate. China and Saudi Arabia are two countries that have chosen to peg their currencies to the US dollar.

Short-term movements in a floating exchange rate currency reflect speculation, rumors, natural calamities, and the currency’s daily supply and demand. When supply exceeds demand, the currency falls, and when demand exceeds supply, the currency rises. A currency that is either too high or too low in value can have a detrimental impact on the economy, impacting commerce and the capacity to pay obligations. The government or central bank will try to put in place policies that will allow its currency to trade at a more advantageous rate.

Macro Factors

Exchange rates are influenced by a variety of macro variables. In a world of international trade, the ‘Law of One Price states that the price of an item in one country should be the same as the price in another. This is referred to as “purchasing price parity” (PPP). If prices go out of whack, a country’s interest rates will alter, or the currency exchange rate will fluctuate. 

Of course, reality does not always follow economic theory, and the law of one price does not always apply in practice owing to a variety of circumstances. Interest rates and comparable prices will still have an impact on exchange rates. Another macro element is a geopolitical risk and a country’s government’s stability. If a country’s government is unstable, its currency is likely to depreciate in comparison to more developed, stable nations.

Maintaining rates

Some countries may choose to employ a pegged exchange rate, which is established and maintained by the government artificially. This rate will not change during the day and will be adjusted on revaluation dates. Emerging-market governments frequently do this to keep the value of their currencies stable. To keep the pegged foreign exchange rate steady, the country’s government must maintain considerable reserves of the currency to which it is tied in order to limit supply and demand fluctuations.