Foreign Exchange being a commodity likes any other commodities the exchange rates tend to fluctuate from time to time. There are various factors that cause the fluctuation in the rates of exchange. These factors can be divided into several following groups. These groups can affect the exchange rates on a short term as well as long-term basis.

1. Fundamental Factors:

The fundamental factors include all such events that affect the basic economic and fiscal policies of the concerned government. These factors normally affect the long-term exchange rates of any currency. On short-term basis on many occasions, these factors are found to be rather inactive unless the market attention has turned to fundamentals. However, in the long run exchange rates of all the currencies are linked to fundamental causes. The fundamental factors are basic economic policies followed by the government in relation to inflation, balance of payment position, unemployment, capacity utilization, trends in import and export, etc. Normally, other things remaining constant the currencies of the countries that follow the sound economic policies will always be stronger. Similar for the countries which are having balance of payment surplus, the exchange rate will always be favourable. Conversely, for countries facing balance of payment deficit, the exchange rate will be adverse. Continuous and ever growing deficit in balance of payment indicates over valuation of the currency concerned and the dis-equilibrium created can be remedied through devaluation.

2. Political and Psychological factors:

Political and psychological factors are believed to have an influence on exchange rates. Many currencies have a tradition of behaving in a particular way for e.g. Swiss franc as a refuge currency. The US Dollar is also considered a safer haven currency whenever there is a political crisis anywhere in the world.

3. Technical Factors:

The various technical factors that affect exchange rates can be mentioned as under:

(a) Capital Movement: The phenomenon of capital movement affecting the exchange rate has a very recent origin. Huge surplus of petroleum exporting countries due to sudden spurt in the oil prices could not be utilized by these countries for home consumption entirely and needed to be invested elsewhere productively. Movement of these petro dollars, started affecting the exchange rates of various currencies. Capital tended to move from lower yielding to higher yielding currencies and as a result the exchange rates moved.

(b) Relative Inflation Rates: It was generally believed until recently that one prima-facie direction for exchange rates to move was in the direction adjusted to compensate the relative inflation rates. For instance, if a currency is already overvalued, i.e., stronger than what is warranted by relative inflation rates, depreciation sufficient enough to correct that position can be expected and vice versa. It is necessary to note that exchange rate is a relative price and hence the market weighs all the relevant factors in a relative term, (in relation to the counterpart countries). The underlying reasoning behind this conviction was that a relatively high rate of inflation reduces a country's competitiveness in international markets and weakens its ability to sell in foreign markets. This will weaken the expected demand for foreign currency (increase in supply of domestic currency and decrease in supply of foreign currency). But during 1981-85 period exchange rates of major currencies did not confirm the direction of relative inflation rates. The rise of the dollar persistently for such a long period discredited this principle.

(c) Exchange rate policy and intervention: Exchange rates are also influenced in no small measure by expectation of changes in regulation relating to exchange markets and official intervention. Official intervention can smoothen an otherwise disorderly market but it is also the experience that if the authorities attempt half-heartedly to counter the market sentiments through intervention in the market, ultimately more steep and sudden exchange rate swings can occur. In the second quarter of 1985 the movement of exchange rates of major currencies reflected the change in the US policy in favour of co-ordinated exchange market intervention as a measure to bring down the value of dollar.

(d) Interest Rates: An important factor for movements in exchange rates in recent years has been difference in interest rates; i.e. interest differential between major countries. In this respect the growing integration of the financial markets of major currencies, the revolution in telecommunication facilities, the growth of specialized asset managing agencies, the deregulation of financial markets by major countries, the emergence of foreign exchange trading etc. having accelerated the potential for exchange rates volatility.

4. Speculation

Speculation or the anticipation of the market participants many a times is the prime reason for exchange rate movements. The total foreign exchange turnover worldwide is many a times the actual goods and services related turnover indicating the grip of speculators over the market. Those speculators anticipate the events even before the actual data is out and position themselves accordingly in order to take advantage when the actual data confirms the anticipations. The initial positioning and final profit taking make exchange rates volatile. These speculators many a times concentrate only on one factor affecting the exchange rate and as a result the market psychology tends to concentrate only on that factor neglecting all other factors that have equal bearing on the exchange rate movement. Under these circumstances even when all other factors may indicate negative impact on the exchange rate of the currency if the one factor that the market is concentrating comes out positive the currency strengthens.

5. Others
The turnover of the market is not entirely trade related and hence the funds placed at the disposal of foreign exchange dealers by various banks, the amount which the dealers can raise in various ways, banks' attitude towards keeping open position during the course of a day, at the end of the day, on the eve of weekends and holidays, window dressing operations as at the end of the half year to year, end of the month considerations to cover operations for the returns that the banks have to submit the central monetary authorities etc. - all affect the exchange rate movement of the currencies.


Guest Author: Ender22 Jan 2013

Yeah, exchange rates seem pretty straight forward, until you start factoring (http://www.jdfactors.com )in all of these kinds of things. It is crazy every time I go out of country on a business trip. Thanks a ton!