Foreign exchange, or forex, is the conversion of one country's currency into another. In a free economy, a country's currency is valued according to the laws of supply and demand. In other words, a currency's value can be pegged to another country's currency, such as the U.S. dollar, or even to a basket of currencies. A country's currency value may also be set by the country's government.
However, many countries float their currencies freely against those of other countries, which keeps them in constant fluctuation.
Factors Affecting Currency Value
The value of any particular currency is determined by market forces based on trade, investment, tourism, and geopolitical risk. Every time a tourist visits a country, for example, they must pay for goods and services using the currency of the host country. Therefore, a tourist must exchange the currency of their home country for the local currency. Currency exchange of this kind is one of the demand factors for a particular currency.
Key Takeaways
- Foreign exchange, also known as forex, is the conversion of one country's currency into another.
- The value of any particular currency is determined by market forces related to trade, investment, tourism, and geopolitical risk.
- Foreign exchange is handled globally between banks and all transactions fall under the auspice of the Bank for International Settlements (BIS).
Another important factor of demand occurs when a foreign company seeks to do business with another in a specific country. Usually, the foreign company will have to pay in the local company's currency. At other times, it may be desirable for an investor from one country to invest in another, and that investment would have to be made in the local currency as well. All of these requirements produce a need for foreign exchange and contribute to the vast size of foreign exchange markets.
Foreign exchange is handled globally between banks and all transactions fall under the auspice of the Bank for International Settlements (BIS).
How Inflation Affects Foreign Exchange Rates
Inflation can have a major effect on the value of a country's currency and its foreign exchange rates with other currencies. While it is just one factor among many, inflationis more likely to have a significant negative effect on a currency's value andforeign exchange rate. A low rate of inflation does not guarantee a favorable exchange rate, but an extremely high inflation rate is very likely to have a negative impact.
Inflation is also closely related tointerest rates, which can influence exchange rates. The interrelationship between interest rates and inflation is complex and often difficult for currency-issuing countries to manage. Low interest rates spurconsumer spendingandeconomic growth, and generally positive influences on currency value. If consumer spending increases and demand grows to exceed supply, inflation may ensue, which is not necessarily a bad outcome. However, low interest rates don't usually attract foreign investment the way higher interest rates can. Higher interest rates attractforeign investment, which is likely to increase demand for a country's currency.
FAQs
Foreign Exchange Rate Market Supply and Demand
What are the factors that affect the foreign exchange? ›
- Inflation. Inflation is a general rise in prices in an economy, i.e., goods, and services and is usually expressed in percentages. ...
- Interest rates. ...
- Government/Public debt. ...
- Political stability. ...
- Economic recession. ...
- Terms of Trade. ...
- Current account deficits. ...
- Confidence and speculation.
Summary. Currency value is determined by aggregate supply and demand. Supply and demand are influenced by a number of factors, including interest rates, inflation, capital flow, and money supply.
What is affecting the exchange rate? ›
If a country has a strong economy, this will usually lead to an increase in the value of its currency. On the other hand, if a country's economy is weak, this will typically cause the value of its currency to decline. Central bank policy: Changes in a central bank's monetary policy can also affect exchange rates.
What are the 3 factors affecting the demand for foreign currency? ›
expected return, risk and liquidity.
What determines foreign exchange rates? ›
In a floating regime, exchange rates are generally determined by the market forces of supply and demand for foreign exchange. For many years, floating exchange rates have been the regime used by the world's major currencies – that is, the US dollar, the euro area's euro, the Japanese yen and the UK pound sterling.
What are the three factors that determine exchange rates? ›
Exchange rates are ultimately determined in global foreign exchange markets by the supply and demand of currencies. Economic factors like inflation, interest rates, and geopolitical events influence these market forces.
What affects a currency value? ›
Numerous factors influence exchange rates, including a country's economic performance, the outlook for inflation, interest rate differentials, capital flows and so on. A currency's exchange rate is typically determined by the strength or weakness of the underlying economy.
What factors affect the value of the dollar? ›
A large number of factors influence currency value. Whether the U.S. dollar depreciates in relation to another currency depends on the monetary policies of both nations, trade balances, inflation rates, investor confidence, political stability, and reserve currency status.
What are three 3 main risks of currency exchange? ›
There are three main types of foreign exchange risk, also known as foreign exchange exposure: transaction risk, translation risk, and economic risk.
The Kuwaiti dinar (KWD) is the world's strongest currency, and this is for a number of reasons. For starters, Kuwait has one of the largest oil reserves in the world.
How does foreign exchange affect the economy? ›
The exchange rate affects the real economy most directly through changes in the demand for exports and imports. A real depreciation of the domestic currency makes exports more competitive abroad and imports less competitive domestically, thereby increasing demand for domestically produced goods.
Which currency has the highest value? ›
Kuwaiti Dinar (KWD) is the world's most valuable currency.
How to improve exchange rate? ›
To strengthen the exchange rate, the central bank simply raises its policy interest rate. As investors in search of higher returns increase their demand for the currency, the exchange rate appreciates. By lowering interest rates, the central bank can weaken the exchange rate.
Is a higher or lower exchange rate better? ›
Overview of Exchange Rates
1 A lower-valued currency makes a country's imports more expensive and its exports less expensive in foreign markets. A higher exchange rate can be expected to worsen a country's balance of trade, while a lower exchange rate can be expected to improve it.
How does inflation affect exchange rates? ›
In general, when inflation is high, it makes a currency weaker, suppressing investment, and thus negatively impacting the exchange rate. When inflation is low, a currency is stronger, improving its exchange rate.
What are the factors affecting the foreign market? ›
Aside from factors such as interest rates and inflation, the currency exchange rate is one of the most important determinants of a country's relative level of economic health. A higher-valued currency makes a country's imports less expensive and its exports more expensive in foreign markets.
What are the effects of foreign exchange in the economy? ›
The exchange rate affects the real economy most directly through changes in the demand for exports and imports. A real depreciation of the domestic currency makes exports more competitive abroad and imports less competitive domestically, thereby increasing demand for domestically produced goods.
What are the factors of exposure in foreign exchange? ›
Exchange rate risk refers to the risk that a company's operations and profitability may be affected by changes in the exchange rates between currencies. Companies are exposed to three types of risk caused by currency volatility: transaction exposure, translation exposure, and economic or operating exposure.
What are the most influential factors affecting foreign trade? ›
These include factor endowments and productivity, trade policy, exchange rates, foreign currency reserves, inflation, and demand.
