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DETERMINATION OF FOREIGN EXCHANGE RATES

Exchange rates respond quickly to all sorts of events, both tangible and psychological: business cycles, balance of payments statistics, political developments, new tax laws, stock market news, expectations for inflation, international investment patterns, government and central bank policies, and many other things.

At the heart of all this complexity, though, are the same forces of supply and demand that determine the prices of goods and services in any free market. If, at current exchange rates, the demand for a currency is greater than the supply, its price tends to rise; if supply exceeds demand, the price tends to fall.

The supply of a given currency is heavily influenced by the country's monetary authorities (usually the country's central bank), consistent with the amount of spending taking place in the economy. Governments and central banks must closely monitor economic activity to keep the money supply at a level appropriate to achieve their economic goals. Too much money in the economy can lead to inflation, with the value of money declining and prices rising; too little money can lead to sluggish economic growth and rising unemployment. Monetary authorities must decide whether economic conditions call for a larger or smaller supply of money.

The condition of a country's economy plays a big role in the demand for its currency on the FX market. The currency of a country with a growing economy, relative price stability and a wide variety of competitive goods and services for sale would be more in demand than that of a country in political turmoil, with high inflation and only a few marketable exports.

But it is not only the demand for a nation's tangible goods that influences exchange rates. Money will flow to wherever it can get the highest return with the least risk. If a nation's financial instru­ments, such as stocks and bonds, offer high rates of return at relatively low risks, foreigners may buy currency to invest in them. In addition, FX traders' speculation within the market about the likelihood of different events will also move exchange rates. For example:

• News of political instability in different parts of the world often causes the U.S. dollar to rise as investors buy dollars, seeking a "safe haven" for their money in the world's largest economy.

• A country's interest rates rise and its currency appreciates, as foreign investors seek a higher return than they can get in their own countries.

• A developing nation implements a low-inflation program of economic growth widely believed to have good prospects for success; its currency rises as foreign investors seek new opportunities. However, if the government is suddenly replaced and economic plans are changed radically, the currency's value in foreign exchange markets may plummet as foreigners seek to withdraw their money.

Conversations like this one occur thousands of times every day in the foreign exchange market, as traders buy and sell currencies, talk about the markets and exchange information. Of the estimated $880 billion that is traded every day, less than 20 percent is traded for the import and export needs of companies and individuals or for direct foreign investment. The majority of trading is done to try to profit from short-term fluctuations in exchange rates, to manage existing positions or to purchase foreign financial instruments.



In the volatile FX market, traders constantly try to predict the behavior of other market participants. If they can correctly anticipate other traders' strategies, they can act first and beat the competition. FX traders make money for their firms by buying currency and selling it later at a higher price, or, anticipating that the market is heading down, by selling at a high price first and buying back at a lower price later. If a trader purchases a lot of a currency, he is said to be long that currency (long dollars, long yen, etc.); conversely, if a trader sells a currency, he is said to be short (short sterling, short francs, etc.).

In order to predict movements in exchange rates, traders often try to determine if a particular currency's price reflects a realistic value in terms of current economic conditions. Analysts attempt to determine a currency's actual value by examining inflation, interest rates and the relative strength of the country's economy. They assume that the price will move up if the currency is underpriced, and down if overpriced.


Date: 2015-12-24; view: 752


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