While assessing the factors influencing exchange rates which control the Forex Market, the experts usually consider the Theory of International parity conditions, Asset market model and Balance of payments model. Let us first examine how these conditions work.
* Conditions of International parity. International parity conditions take into consideration the Relative Interest rate parity, purchasing power parity, Domestic fisher effect and International Fisher effect in which the Fisher effect relates the inflation and both the real and nominal interest rates. Though the above theories provide some logical explanation to exchange rate fluctuations they are faulty as they are based on explanations which are challengeable as the free flow of goods and services and capital for which the true condition on earth can never be stated.
* Assets Market Model: The currencies are considered here as important class of asset used for construction of investment portfolios. In fact, the existence of these assets mainly depends on people and their willingness to hold these assets and their expectations on the asset value. Due to the unpredictable nature and condition of these assets they may influence the exchange rates in short term but they are unable to determine long-term fluctuations.
* Balance of Payments Model: Although the Balance of Payments model focuses mainly on tradable goods and services it ignores the increasing role of capital flow in the global market. From the above we can understand that many factors affect the currency exchange rates and in a nutshell, we can conclude that the main factor which influence currency rates is Demand and Supply as which determines the value of any commodity. Only if we analyze the factors which influence Demand and Supply of a particular currency which in turn shed some light on conditions which truly affect currency rates. The Economic factors, Political conditions, Market psychology, The Government’s fiscal policy related to budget and spending practices and Monitory Policy by which the Central bank of the country influences the supply and cost of money which in turn determines the interest rates and ultimately control the Demand and Supply of the Country’s currency.
* Government’s budget deficits or surpluses: The foreign exchange market usually reacts adversely on budget deficits and positively on budget surpluses, which indicates the demand for the country’s currency and the traders usually tempt to buy the currency when the budget shows surpluses and the contrary on deficits.
* Balance of Trade and Trends levels: The increase in trade flow between countries positively affect the currency which increases the sales of goods and services to another country. Surplus and deficit in the trade of goods and services reflect the competitiveness of a country’s economy. Also, the trade deficit can have negative impact. Inflation levels and the trend for inflation, the health of Economic growth of a country, also the productivity of economy should positively influence the currency value of a country and also it affects adversely when the country faces financial difficulties. Also, the Internal, regional and international political events and conditions affect currency markets. Market psychology and trader perceptions affect currency exchange market. While the country is seemed to have unsettled or unpredictable events like war or political uncertainty the traders tend to move their assets to safer havens. Such situation increases or decreases the demand and price of a particular currency. The US dollar, Swiss Franc and gold have been traditionally considered safe assets during times of political or economic uncertainty.
* Long term trends: Currency markets usually move in line with long term trends although the currencies do not have an annual growing season like physical commodities they move in business cycles.
* ‘Buy the rumor and sell the fact’: The currencies have a tendency to reflect the impact of a particular situation before it occurs. A situation like ‘Buy the rumor and sell the fact, is applicable to currency trade and when the actual situation occurs the market behaves exactly in the opposite direction. Economic numbers and Technical trading considerations also influence the value of currencies and it reflect on the forex market.
