Foreign Exchange being a commodity likes any other commodities the exchange rates tend to fluctuate from time to time. There are various factors that cause the fluctuation in the rates of exchange. These factors can be divided into several following groups. These groups can affect the exchange rates on a short term as well as long-term basis.
1. Fundamental Factors:
The fundamental factors include all such events that affect the basic economic and fiscal policies of the concerned government. These factors normally affect the long-term exchange rates of any currency. On short-term basis on many occasions, these factors are found to be rather inactive unless the market attention has turned to fundamentals. However, in the long run exchange rates of all the currencies are linked to fundamental causes. The fundamental factors are basic economic policies followed by the government in relation to inflation, balance of payment position, unemployment, capacity utilization, trends in import and export, etc. Normally, other things remaining constant the currencies of the countries that follow the sound economic policies will always be stronger. Similar for the countries which are having balance of payment surplus, the exchange rate will always be favourable. Conversely, for countries facing balance of payment deficit, the exchange rate will be adverse. Continuous and ever growing deficit in balance of payment indicates over valuation of the currency concerned and the dis-equilibrium created can be remedied through devaluation.
2. Political and Psychological factors:
Political and psychological factors are believed to have an influence on exchange rates. Many currencies have a tradition of behaving in a particular way for e.g. Swiss franc as a refuge currency. The US Dollar is also considered a safer haven currency whenever there is a political crisis anywhere in the world.
3. Technical Factors:
The various technical factors that affect exchange rates can be mentioned as under:
(a) Capital Movement: The phenomenon of capital movement affecting the exchange rate has a very recent origin. Huge surplus of petroleum exporting countries due to sudden spurt in the oil prices could not be utilized by these countries for home consumption entirely and needed to be invested elsewhere productively. Movement of these petro dollars, started affecting the exchange rates of various currencies. Capital tended to move from lower yielding to higher yielding currencies and as a result the exchange rates moved.
(b) Relative Inflation Rates: It was generally believed until recently that one prima-facie direction for exchange rates to move was in the direction adjusted to compensate the relative inflation rates. For instance, if a currency is already overvalued, i.e., stronger than what is warranted by relative inflation rates, depreciation sufficient enough to correct that position can be expected and vice versa. It is necessary to note that exchange rate is a relative price and hence the market weighs all the relevant factors in a relative term, (in relation to the counterpart countries). The underlying reasoning behind this conviction was that a relatively high rate of inflation reduces a country's competitiveness in international markets and weakens its ability to sell in foreign markets. This will weaken the expected demand for foreign currency (increase in supply of domestic currency and decrease in supply of foreign currency). But during 1981-85 period exchange rates of major currencies did not confirm the direction of relative inflation rates. The rise of the dollar persistently for such a long period discredited this principle.
(c) Exchange rate policy and intervention: Exchange rates are also influenced in no small measure by expectation of changes in regulation relating to exchange markets and official intervention. Official intervention can smoothen an otherwise disorderly market but it is also the experience that if the authorities attempt half-heartedly to counter the market sentiments through intervention in the market, ultimately more steep and sudden exchange rate swings can occur. In the second quarter of 1985 the movement of exchange rates of major currencies reflected the change in the US policy in favour of co-ordinated exchange market intervention as a measure to bring down the value of dollar.
(d) Interest Rates: An important factor for movements in exchange rates in recent years has been difference in interest rates; i.e. interest differential between major countries. In this respect the growing integration of the financial markets of major currencies, the revolution in telecommunication facilities, the growth of specialized asset managing agencies, the deregulation of financial markets by major countries, the emergence of foreign exchange trading etc. having accelerated the potential for exchange rates volatility.
4. Speculation
Speculation or the anticipation of the market participants many a times is the prime reason for exchange rate movements. The total foreign exchange turnover worldwide is many a times the actual goods and services related turnover indicating the grip of speculators over the market. Those speculators anticipate the events even before the actual data is out and position themselves accordingly in order to take advantage when the actual data confirms the anticipations. The initial positioning and final profit taking make exchange rates volatile. These speculators many a times concentrate only on one factor affecting the exchange rate and as a result the market psychology tends to concentrate only on that factor neglecting all other factors that have equal bearing on the exchange rate movement. Under these circumstances even when all other factors may indicate negative impact on the exchange rate of the currency if the one factor that the market is concentrating comes out positive the currency strengthens.
5. Others
The turnover of the market is not entirely trade related and hence the funds placed at the disposal of foreign exchange dealers by various banks, the amount which the dealers can raise in various ways, banks' attitude towards keeping open position during the course of a day, at the end of the day, on the eve of weekends and holidays, window dressing operations as at the end of the half year to year, end of the month considerations to cover operations for the returns that the banks have to submit the central monetary authorities etc. - all affect the exchange rate movement of the currencies.
FACTORS AFFECTING FOREIGN EXCHANGE RATES
DETERMINATION OF EXCHANGE RATES
There is no generally accepted theory or model to determine exchange rates. However, there are certain approaches which provide a general frame-work for analysis of exchange rates which are discussed below:
(a) Balance of Payments: If payments by a country for its imports of goods and services and invisibles are out of step with its receipts for exports of goods and services and invisible, two possibilities arise. One foreign currency payments exceed receipts and there is a deficit. This puts the home currency of the country under downward pressure against foreign currencies. Two, there is a surplus and there is an upward pressure on the home currency. In the former case, the home currency tends to depreciate, and in the later to appreciate, against foreign currencies.
(b) Demand and supply: The demand for a foreign currency to pay for imports, etc, and the supply of a foreign currency by way of receipts on account of exports, etc. vary at various rates of exchange. The rate which equilibrates the demand and supply should be the rate of exchange.
(c) Purchasing power parity: This theory maintains that free international trade equalises prices of tradable goods in different countries. So, a product will sell for the same price in common currency in all countries. Different rates of changes in prices i.e. different inflation rates must eventually induce off-setting changes in exchange rates in order to restore approximate price equality. Mathematically, the rate (or the expected rate) of change of the exchange rate should equal the rate (or the expected rate) of change of the inflation rate. Evidence shows that there do exist disparities between changes in observed exchange rates and those in inflation rates in the short-run. But, the theory should hold in the long-run.
(d) Interest rate: Interest rates are often highly related with inflation rates, and interest rate differentials between countries may be the result of inflation rate differentials. Therefore, interest rate differentials are also used as an important determinant of exchange rates.
Interest rates in a country are determined, under free market conditions, by supply of and demand for money. Funds flow across countries in search of opportunities for higher returns. These flows between any two countries cause opposite changes in demand of and supply for their respective currencies. According to the theory of International Fisher Effect, the exchange rate of a currency with higher interest rate will depreciate to offset the interest rate advantage achieved by foreign investments till an equilibrium is achieved.
Investments abroad have to be converted into home currency on maturity. Exchange rate may have changed in the meanwhile. An investor may make a forward sale of funds to be rapatriated on maturity. The process of investing abroad for higher returns and making a forward sale of the proceeds is known as covered interest arbitrage. An investment abroad will be undertaken if the return from interest rate differential exceeds the forward margin (difference between the forward and spot exchange rates). In general terms, the forward rate of the foreign currency will contain a discount (premium) if its interest rate is higher (lower) that that of the home currency. Covered interest arbitrages will go on fill the market forces realign the forward margins with the interest rate differentials.
(e) Relative Income Levels: If income level in a country raises and that in her trading partner remains unchanged, the demand by the former for the goods of the later may increase. That is, the former would need more units of currency of the later, while their supply remains unchanged. This would put upward pressure on the exchange rate of the later. There can be different configurations of the relative income levels and of corresponding exchange rates.
(f) Market expectations: Like other financial markets, foreign exchange markets react to any news that may have an effect on exchange rates in future. Expected developments regarding polity, economy etc. of a country are used to figure out how exchange rates would move. These peeps into future impinge on the present as well as the future spot rates.