Foreign exchange is important because it determines the value of the foreign investment. Therefore, a volatile exchange rate will not encourage foreign investment.
Similarly, a high and stable exchange rate also discourages foreign exchange. However, a low exchange rate encourages foreign investment at the price of a low-valued currency’s economy.
A Volatile Exchange Rate
If an exchange rate is volatile, it becomes impossible for foreign investors to predict their returns. Even if the investors invest in holdings known for giving stable returns, if the foreign currency is prone to fluctuations, a good return is not guaranteed.
A High and Stable Value
A currency with a high value discourages export markets but encourages import markets. The reason being that foreign investors can increase their ROI (Return on Investment) by making profits in a different currency. The export market, on the other hand, suffers because they are valued in their home country, not abroad.
A Low and Stable Value
A currency with a low value and stability encourages exports rather than imports because goods sold abroad for high-valued currencies are worth more than their face value. However, when the currency’s value is low, there are no benefits for the import market.
The Effect of Interest Rate on the Dollar
Interest rates are usually a motivating factor for foreign investors to move their investment from one country to another. As a result, high-interest rates in the United States will increase the value of the dollar. Conversely, low interest rates will depreciate the value of the dollar.
Interest Rates to Induce Investment from Foreign Investors
By increasing the interest rates, a country can attract foreign investment. The logic is the same for any other type of investment, and investors are always seeking risk-adjusted returns. Therefore, high interest rates will also increase the return for investors. On the other hand, the demand for the country’s currency will also rise.
Interest Rate and Inflation
For several countries, especially developing countries, high interest rates also impact inflation, resulting in high inflation levels. Even though the nominal interest rate is more appealing, the real interest rate is much lower. The high inflation level also depreciates the value of the currency.
Effects of Exchange Rate Changes
Governments might sometimes influence exchange rates to influence the economy. The influence may also be direct by buying and selling domestic currency in the foreign exchange market.
The government can also influence the exchange rate indirectly by affecting aggregate demand, inflation, the Balance of payments, and employment. For example, sometimes, to decrease imports and inflation, the government may increase exchange rates by increasing the value of short-term interest rates.
On the other hand, the government may also decrease the exchange rate to achieve macroeconomic goals (improving BOP).
Export Changes
As we have already discussed, depreciation in the currency’s value will decrease the price of exports abroad and lead to an increase in the demand for exports.
Import Changes
Depreciation in the value of a currency will also increase the price of imports and increase demand for imports. Here, the policy of the government will be to manipulate the exchange rate to achieve economic goals.
Factors that Affect the Exchange Rate
The foreign exchange rate determines the health of a country’s economy. Therefore, the foreign exchange rate is constantly analyzed and watched. Below we have discussed some factors that affect the exchange rate.
- Inflation Rates
Changes in market inflation cause fluctuations in the exchange rate, and a country with a low inflation rate will see a rise in the value of its currency. Conversely, when the market inflation rate is low, the prices of goods and services increase slowly.
On the contrary, a country with a high inflation rate sees depreciation in the value of its currency.
- Interest Rates
Fluctuations in interest rates affect the exchange rate and value of the currency. There is also a correlation between Forex rates, exchange rates, and inflation. Therefore, an increase in interest rate would increase the value of the country’s currency, and more foreign investors will be attracted.
- Balance of Payments
The Balance of payments or current account of a country reflects earnings of trade and foreign investment. The Balance of payment also consists of a total number of imports, exports, and debts.
A current account deficit caused by spending the currency on imported goods would decrease sales of exports. The Balance of payments also fluctuates the exchange rate of the domestic currency.
- Government Debts
Government debt, also known as national or public debt, is owned by the country’s government. A country with government debt is unlikely to acquire foreign capital, which increases inflation.
If the market predicts the government debt, foreign investors will sell the bonds in the open market. This causes a decrease in the exchange rate of a country.
- Trade Terms
Trade terms are related to the Balance of payments and current accounts. Terms of trade are prices of export to prices of import. The terms of trade of a country will improve if export prices are greater than import prices. The result will be a higher revenue, which increases the demand for the currency and its value.
- Political Stability
The political state of a country can have the value and strength of its currency. A country that has a stable political situation is more likely to foreign investors. An increase in foreign investment will lead to an appreciation in the value of the currency.
- Recession
When a country is going through a period of recession, its interest rates fall drastically. Once the interest rates fall, the country cannot attract foreign investors, and the value of its currency depreciates significantly.
- Speculation
If the value of a country’s currency is expected to rise, foreign investors will demand more of the currency to have a profitable future. The increase in demand for the currency will also raise its value. The exchange will also rise due to this.
Foreign Exchange Market
Forex trading is when a trader buys a currency and sells a different one, and the exchange range fluctuates according to the demand and supply. The trade for currencies takes place in the foreign exchange market that is open from Monday to Friday.
The Foreign exchange market is open 24 hours a day. All currencies are traded over the counter (OTC), which means there are no physical exchanges, and a worldwide network of financial institutions and banks oversee the operations. As a result, the vast majority of trading in the market is between institutional traders.
Different Ways of Trading Forex
There are three ways to trade Forex:
- Spot Market: This is the primary market for trading forex; here, pairings of currencies are swapped, and the exchange rate is determined based on demand and supply.
- Forward Market: Instead of initiating a trade, traders can have a binding contract with another trader in the forward market. The two parties will also decide the exchange rate, amount of currency, and a future date.
- Futures Market: Like the forward market, traders can opt for a contract to sell or buy a fixed amount of the currency at a specific exchange rate in the futures market.
Forex Trading Frequently Asked Questions (FAQ)
- Who owns Forex, and where is it located?
Forex does not have a particular owner; it is an interbank market, which means transactions occur between a seller and a buyer. Therefore, as long as the current banking system exists, Forex will exist as a specific government or country that does not run it.
- Working Hours of Forex?
Forex opens at 22:00 GMT on Sunday (Australian trading session opens) and closes on Friday 22:00 GMT (US trading session closes)
- How Much Money is Needed to Start Forex?
Some traders start trading with just a dollar; however, the starting amount varies from 100 to 100,000 dollars.
- Best Strategy for Forex?
No one strategy is better than the other one; traders must develop new strategies all the time. Some Forex strategies are only beneficial in the short term.
- Can I Lose more than What I Invest in Forex?
Not really; the broker will not let the trader face huge losses and will not allow the loss to be greater than the amount in the trading account.
Functions of the Forex Market
Below we have some key functions of the Forex market:
- First, to transfer the purchasing power and finance from one country to another. This transfer is usually carried out through remittances or foreign bills.
- To provide credit for international trade.
- To make provisions for hedging facilities, to facilitate forward foreign exchange, buying and selling spot.
- Transfer Function
The major function of the Forex market is to facilitate the conversion of different currencies. The conversion of currencies also leads to the transfer of purchasing power between nations. The transfer of purchasing power can be affected by the following factors:
- Foreign bills
- Telegraphic transfer
- Bank drafts
- Credit Function
Another key function of the Forex market is the credit function. The market both national and international credit to facilitate foreign trade. When foreign bills are used for international payments, a credit of three months is needed.
- Hedging Function
The third main function of the Forex market is the hedging function. The main purpose of this function is to hedge risks, such as avoiding foreign exchange risk. When the price of a currency change in terms of another currency in a free exchange market, the parties involved either gain or suffer a loss.
Conclusion
In this article, we have touched upon the importance of currency exchange. The exchange of currency happens regularly, and many factors affect it. We also discussed exchange rates, interest rates, and how they play an important role in increasing or decreasing the value of a currency.
We also discussed the foreign exchange market (Forex) and its key functions. Once you are done reading this article, you will have a clear idea about what currency exchange is.
We also mentioned how important the economy is and how the government will sometimes manipulate the exchange rate for their benefit. Lastly, we have also discussed the different methods of Forex traded and the risks involved in it.