Forex trading can be easy if you understand the factors controlling its market, and to be a successful trader or investor in foreign exchange, you need to watch these factors closely. The price of a currency or its exchange value can vary depending on the demand and supply. It may look simple, but various factors or a different combination of factors can affect the supply and demand for forex, leading to the determination of its exchange value.
One better way to better understand the forex market is to follow forex news updates from reputed financial websites. The forex-related news and expert columns can give you a better insight into the various aspects of trading.
Let us look into eight essential factors that affect the forex market.
Economic progress
The prime factor that controls the exchange value of a currency compared to other currencies is the economic power of that country. Currencies of the world’s top economies are attractive to buyers and investors because of the power such economies wield. In simple terms, the exchange rate of that currency is directly related to the Gross Domestic Product (GDP) value of the country’s economy. Investors will always prefer currencies of high-income countries. On the other hand, the exchange value of a currency tells you about the relative strength of a country’s economy.
Political stability
Another factor that affects the currency of a country is the political situation. People will abandon the money of a country if its political stability weakens. We had seen this in Sri Lanka recently when political protests rattled the nation. The demand for US dollars shot up in the country, which has affected the exchange value of the Sri Lankan rupee. The US dollar price shot up sharply as the Sri Lankan rupee collapsed.
Inflation and interest rate
The leading economic factor that affects the forex market is inflation. When the inflation rate goes up in a country, the valuation of its currency will go down as the purchasing power of that currency declines. It is one reason why governments worldwide are wary of the inflation rate, and the central banks try to control inflation by manipulating the interest rate and the money supply.
A higher interest rate can also attract foreign capital and raise the exchange rate. When the interest rate is low, the exchange rate too will go down if other factors are negligible.
Usually, forex traders watch the Consumer Price Index (CPI) of a country find the rate of inflation prevailing in the country.
Current account balance
The current account balance of a country is the difference between the value of its exports and imports and earnings from its foreign investments. If a country’s import expenditure is higher than its export value, the government will have a current account deficit, meaning it will have to borrow from out to settle the account. It will affect the exchange rate of its currency as well.
Terms of trade
A country’s terms of trade are positive when the price of its exports is greater than the price of its imports. It leads to a higher demand for the country’s currency and an appreciation in its value. The reverse will result when the import burden is greater than export earnings. But a fall in the exchange value of the local currency is beneficial for exporters and remitters.
Public debt
Countries with a sizeable public debt due to external and internal borrowing will find the exchange rate of their currencies going down in valuation. Sizeable public debt will lead to inflation, inversely related to the exchange rate.
Speculation
Another major factor that affects the exchange value of a currency is speculation. Like the equity market, the forex market is also prone to speculation. For example, if there is growing speculation that the country’s economy is weakening, the value of its currency will decline. But speculators in the forex market usually buy when the exchange value of a currency is cheap in the hope that they can make a good profit when the value goes up.
World events
International events, too can affect the value of a currency. For example, the recent invasion of neighbouring Ukraine by Russia led to a decline in the value of Euro as many European countries are highly dependent on the oil supply from Russia which a sanction by the United States threatens. Interestingly, the decline in the exchange rates of the Euro and the GBP has led to a rise in the dollar value. Speculation surrounding such world events is also a factor in the fluctuation of currencies.
It may be in the interest of an investor or trader in foreign exchange to be knowledgeable about these factors as the forex market is highly volatile. Any of the above factors can lead to a market rally or fall.