Exchange rate between two currencies specifies how much one currency is worth in terms of another. Any foreign exchange deal is always done in currency pairs e.g. USD/INR. Exchange rates are subject to market conditions, which increases risk associated with such deals. E.g. if person ‘A’ does business with person ‘B’ and the deal is set for $1000, which is supposed to be paid by ‘B’ after one month. Then the value of $1 today will not equal to value of $1 after one month.
Foreign exchange prices are very volatile and fluctuate on a real time basis, depending on many factors. This price fluctuation is expressed as appreciation/depreciation or the strengthening/weakening of a currency relative to the other.
Fixed exchange rate and floating exchange rate
There are mainly two mainly two methods employed by governments to determine the value of domestic currency vis-à-vis other currency.
- Fixed Exchange Rate: When a currency’s value is maintained at a fixed rate to the value of another currency or to a basket of currencies or to any other measure of value like gold, then the currency is subject to fixed exchange rate which is also known as pegged exchange rate. In order to maintain a fixed exchange rate government participates in open currency market and play role of buying and selling currency with following conditions to maintain fixed exchange rate.
- When the value of currency rises beyond the acceptable limit, government sells the currency in open market thereby increasing its supply and reducing its value.
- When the value of currency falls beyond certain limit, government buys currency from open market thereby increasing its demand and value.
- Floating exchange rate: In Floating exchange rate or fluctuating exchange rate regime currency’s value is allowed to fluctuate according to the foreign exchange market. Floating exchange rates are purely determined by market mechanism through supply and demand of currency. Any difference in the value caused due to differences in market demand and supply, currency exchange rate adjusts itself accordingly, thus floating rate is also termed as “self-correcting”. E.g. if demand for currency is low, its value will decrease thus making imported goods more expensive and exports relatively cheaper. The countries buying these export goods will demand the domestic currency in order to make payments, and the demand for domestic currency will increase. This will again lead to appreciation in the value of the currency. Therefore, floating exchange rate is self correcting, requiring no government intervention. However, usually in cases of extreme appreciation or depreciation of the currency, the country’s Central Bank intervenes to stabilize the currency.
Free floating exchange rate increases foreign exchange volatility, emerging economies may get affected badly because of free floating exchange rates. When such economies have liabilities dominated in foreign currencies while assets are in local currency, then unexpected depreciation of currency deteriorate bank and corporate balance sheets which in turn becomes threat to the stability of the domestic financial system. Because of this emerging currencies appear to face greater fear of floating exchange rates.
Factors affecting exchange rate
There are many factors affecting exchange rate of currency, they can be classified as follows
- Fundamental Factors:Fundamental factors include basic economic policies followed by government which includes policies in relation to import and export trends, unemployment, utilization of capacity, balance of payment etc. Economies having surplus balance of payment have favorable exchange rates, where as weak economies have unfavorable exchange rates compare to strong economies
- Technical Factors:There are various technical factors that affects exchange rates are as follows
- Capital Movement: The surplus that was earned by petroleum exporting countries due to sudden rise in oil prices could not be invested in their own countries entirely and therefore it had to be invested somewhere else. The investment of such large funds by petroleum exporting countries affected the exchange rates due to which there was a movement in the capital and the capital started to move from lower yielding currencies to higher yielding currencies and as a result of which there was a change in exchange rates. I.e. the movement of petro dollars started affecting exchange rates of various countries.
- Relative inflation rates: a relatively high rate of inflation reduces a country's competitiveness in international markets and weakens its ability to sell in foreign markets and vice versa. I.e. high inflation rate in country reduces relative competitiveness of export sector of that country which in turns result in lower demand of the domestic currency and therefore the currency depreciates.
- Exchange rate policy and intervention: Exchange rate policy is the most important factor which influences the exchange rates. E.g. a country may decide to follow fixed or floating exchange rates based on this exchange rate movement varies less or more frequently. Government also participates in foreign exchange market to control the demand or supply of domestic currency.
- Interest rates: Rising of interest rates in country may leads to increase in foreign investment, which in turns increases demand for domestic currency which causes appreciation of domestic currency.
- Political and psychological factors:Exchange rates are believed to get influenced by political and psychological factors. Many currencies have tradition of behaving in certain way. E.g. USD is considered to be safer currency.
- Speculation:Many a times the prime reason for the exchange rate movements is the speculation or expectation of market participants. Speculators anticipate the event before the actual data is out and position them accordingly in order to take advantage when actual data is out, the initial positioning and actual profit affects the exchange rate. E.g. Speculators think that currency of a country is overvalued and will depreciate in near future, and then such speculators will pull out the money from particular country resulting in lower demand for currency which results in depreciation of currency.
- Others:Turnover of market is not entirely trade related and hence funds placed at the disposal of foreign exchange dealers by various banks, the amount a dealer can raise in various ways, banks attitude towards keeping open position during the course of the day, at the end of the day, window dressing operations etc all affect the exchange rate movement.
