The following theories explain the fluctuations in exchange rates in a floating exchange rate regime (In a fixed exchange rate regime, rates are decided by its government):
- International parity conditions: Relative purchasing power parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world.
- Balance of payments model: This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during the 1980s and most part of the 1990s in face of soaring US current account deficit.
- Asset market model: views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people's willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.”
None of the models developed so far succeed to explain exchange rates
and volatility in the longer time frames. For shorter time frames (less
than a few days), algorithms
can be devised to predict prices. It is understood from the above
models that many macroeconomic factors affect the exchange rates and in
the end currency prices are a result of dual forces of demand and
supply. The world's currency markets can be viewed as a huge melting
pot: in a large and ever-changing mix of current events, supply and demand
factors are constantly shifting, and the price of one currency in
relation to another shifts accordingly. No other market encompasses (and
distills) as much of what is going on in the world at any given time as
foreign exchange.[74]
Supply and demand for any given currency, and thus its value, are not
influenced by any single element, but rather by several. These elements
generally fall into three categories: economic factors, political
conditions and market psychology.
Economic factors
These include: (a) economic policy, disseminated by government
agencies and central banks, (b) economic conditions, generally revealed
through economic reports, and other economic indicators.
- Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).
- Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.
- Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.
- Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.
- Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.
- Productivity of an economy: Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the increase is in the traded sector.[75]
Political conditions
Internal, regional, and international political conditions and events can have a profound effect on currency markets.
All exchange rates are susceptible to political instability and
anticipations about the new ruling party. Political upheaval and
instability can have a negative impact on a nation's economy. For
example, destabilization of coalition governments in Pakistan
and Thailand can negatively affect the value of their currencies.
Similarly, in a country experiencing financial difficulties, the rise of
a political faction that is perceived to be fiscally responsible can
have the opposite effect. Also, events in one country in a region may
spur positive/negative interest in a neighboring country and, in the
process, affect its currency.
Market psychology
Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:
- Flights to quality: Unsettling international events can lead to a "flight-to-quality", a type of capital flight whereby investors move their assets to a perceived "safe haven". There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The US dollar, Swiss franc and gold have been traditional safe havens during times of political or economic uncertainty.[76]
- Long-term trends: Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends.[77]
- "Buy the rumor, sell the fact": This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought".[78] To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices.
- Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.
- Technical trading considerations: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.[79]
Financial instruments
Spot
Main article: Foreign exchange spot
A spot
transaction is a two-day delivery transaction (except in the case of
trades between the US dollar, Canadian dollar, Turkish lira, euro and
Russian ruble, which settle the next business day), as opposed to the futures contracts,
which are usually three months. This trade represents a “direct
exchange” between two currencies, has the shortest time frame, involves
cash rather than a contract, and interest is not included in the
agreed-upon transaction. Spot trading is one of the most common types of
Forex Trading. Often, a forex broker will charge a small fee to the
client to roll-over the expiring transaction into a new identical
transaction for a continuum of the trade. This roll-over fee is known as
the "Swap" fee.
Forward
See also: Forward contract
One way to deal with the foreign exchange risk is to engage in a
forward transaction. In this transaction, money does not actually change
hands until some agreed upon future date. A buyer and seller agree on
an exchange rate for any date in the future, and the transaction occurs
on that date, regardless of what the market rates are then. The duration
of the trade can be one day, a few days, months or years. Usually the
date is decided by both parties. Then the forward contract is negotiated
and agreed upon by both parties.
Swap
Main article: Foreign exchange swap
The most common type of forward transaction is the foreign exchange
swap. In a swap, two parties exchange currencies for a certain length of
time and agree to reverse the transaction at a later date. These are
not standardized contracts and are not traded through an exchange. A
deposit is often required in order to hold the position open until the
transaction is completed.
Futures
Main article: Currency future
Futures are standardized forward contracts and are usually traded on
an exchange created for this purpose. The average contract length is
roughly 3 months. Futures contracts are usually inclusive of any
interest amounts.
Currency futures contracts are contracts specifying a standard volume
of a particular currency to be exchanged on a specific settlement date.
Thus the currency futures contracts are similar to forward contracts in
terms of their obligation, but differ from forward contracts in the way
they are traded. They are commonly used by MNCs to hedge their currency
positions. In addition they are traded by speculators who hope to
capitalize on their expectations of exchange rate movements.
Option
Main article: Foreign exchange option
A foreign exchange option (commonly shortened to just FX option) is a
derivative where the owner has the right but not the obligation to
exchange money denominated in one currency into another currency at a
pre-agreed exchange rate on a specified date. The FX options market is
the deepest, largest and most liquid market for options of any kind in
the world.
Speculation
Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Economists, such as Milton Friedman, have argued that speculators ultimately are a stabilizing influence on the market, and that stabilizing speculation performs the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it, to those who do.[80] Other economists, such as Joseph Stiglitz, consider this argument to be based more on politics and a free market philosophy than on economics.[81]
Large hedge funds and other well capitalized "position traders" are
the main professional speculators. According to some economists,
individual traders could act as "noise traders" and have a more destabilizing role than larger and better informed actors.[82] Also to be considered is the rise in foreign exchange autotrading; algorithmic, or automated, trading has increased from 2% in 2004 up to 45% in 2010.[83]
Currency speculation is considered a highly suspect activity in many countries.[where?]
While investment in traditional financial instruments like bonds or
stocks often is considered to contribute positively to economic growth
by providing capital, currency speculation does not; according to this
view, it is simply gambling that often interferes with economic policy. For example, in 1992, currency speculation forced the Central Bank of Sweden to raise interest rates for a few days to 500% per annum, and later to devalue the krona.[84] Mahathir Mohamad, one of the former Prime Ministers of Malaysia, is one well-known proponent of this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators.
Gregory Millman
reports on an opposing view, comparing speculators to "vigilantes" who
simply help "enforce" international agreements and anticipate the
effects of basic economic "laws" in order to profit.[85]
In this view, countries may develop unsustainable financial bubbles
or otherwise mishandle their national economies, and foreign exchange
speculators made the inevitable collapse happen sooner. A relatively
quick collapse might even be preferable to continued economic
mishandling, followed by an eventual, larger, collapse. Mahathir Mohamad
and other critics of speculation are viewed as trying to deflect the
blame from themselves for having caused the unsustainable economic
conditions.
Risk aversion
See also: Safe-haven currency
Risk aversion is a kind of trading behavior exhibited by the foreign
exchange market when a potentially adverse event happens which may
affect market conditions. This behavior is caused when risk averse
traders liquidate their positions in risky assets and shift the funds to less risky assets due to uncertainty.[86]
In the context of the foreign exchange market, traders liquidate
their positions in various currencies to take up positions in safe-haven
currencies, such as the US dollar.[87]
Sometimes, the choice of a safe haven currency is more of a choice
based on prevailing sentiments rather than one of economic statistics.
An example would be the Financial Crisis of 2008. The value of equities
across the world fell while the US dollar strengthened (see Fig.1). This
happened despite the strong focus of the crisis in the USA.[88]
Carry trade
Main article: Carry trade
Currency carry trade refers to the act of borrowing one currency that
has a low interest rate in order to purchase another with a higher
interest rate. A large difference in rates can be highly profitable for
the trader, especially if high leverage is used. However, with all
levered investments this is a double edged sword, and large exchange
rate price fluctuations can suddenly swing trades into huge losses.
Forex signals
Main article: Forex signal
Forex trade alerts, often referred to as "forex signals", are trade
strategies provided by either experienced traders or market analysts.
These signals which are often charged a premium fee for can then be
copied or replicated by a trader to his own live account. Forex signal
products are packaged as either alerts delivered to a user's inbox or SMS,
or can be installed to a trader's trading platforms. Algorithmic
trading, whereby foreign exchange users can programme (or buy ready made
software) to place trades on their behalf, according to pre-determined
rules has become very popular in recent years. This means that users can
set their 'Algos' to trade on their behalf, thus reducing the need to
sit and monitor the markets continuously, plus it can remove the element
of human emotion around executing a trade.
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