Forex trading is nothing but the trading of one currency for another. It is just like any other trade. With each passing day, the number of people interested in forex is on the rise.
I see lot of my friends trading in forex market. Since they read my blog, One of them asked me to shed some light on forex here. Hence this post on ‘ factors affecting currency in forex trading market’. This to give our other readers the basics before they take the dive.
What is Forex ?
Originally forex was invented as a hedge against risk. If you’re in a business that buys and sells from/to abroad forex is an effective hedge against loss due to currency fluctuation. Forex also helps in currency conversion for individual person which is minor portion of forex market.
Suppose you make a deal to sell X items to a US firm at $6 million after 1 year. Assuming $1=Rs.60 now. You deal value is Rs.360 million. After 1 year , you learn that the conversion rate $1=Rs.50 then. Now the US firm will pay you $6 million but you will get only Rs.300 million ie., 50 * 6million. So you lose total Rs. 60 million.
To prevent this, you take a small exposure with forex futures hedging $6 million at Rs. 60 when you sign the deal. So when you actually get paid, even if Rupee depreciated you will get that deficit of close to Rs. 60 million from forex profits. Of course after deducting any costs involved with futures trading.
As you now have very basic idea of what forex currency trading is, let us see what factors affect a currency.
7 factors affecting a currency in forex trading market
1) Interest Rate differentials among nations
This is the single most important factor affecting a currency. The interest rate differential among nations is first factor affecting exchange rates. Suppose the interest rates on Governement deposits in US are 2% and in India is 8%. Where will you want to invest? Obviously in India (wait there are factors to consider as well).
So as money moves from US to India there is more demand for Rupees which strengthens the Indian currency. Now exchange value of $1 will reduce like Rs.55, Rs.53 until some change in status quo.
As flow increases into a nation, its currency gains value and gets stronger. As the Central Bank of each country decide their interest rates, the difference in interest causes inflow or outflow.
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Inflation is the second best known factor. For example, India has decided to spur business expansion by easing interest rates. And say, India has 3.5% inflation at the time. Not very many money managers would rush to pull their money out of India.
This is because even if it is going to earn less interest, their money would lose less buying power with 1% inflation increase. If they find another country where there is better difference among low inflation rate and higher interest rates, they will eventually move.
But it would not be as hasty as it would be to get out of a currency suffering double-digit inflation. This is what happened to India last year. With inflation on the high, money was flowing out of India.
Remember when everybody was talking $ exchange will reach Rs.65. It will reach Rs. 70 in few days like. This is because Rupee as currency was weakening against the dollar.
The often over looked factor. But shrewd money managers don’t neglect this. Productivity of a nation’s work force can also decide how big money firms manage their money.
Productivity is an important factor for the nation. It is one of the foundations on which the country’s price structure is based. A workforce with higher productivity (more goods every hour or day) can afford to get higher wages and still price their products competitively.
Germany, Japan are among the most productive nations. An interest rate drop of 1% in US will create panic. But the same drop will be less impactful on a currency like Mark or Yen.
Why? In such a productive nation inflation is unlikely to rise to a point where real rate of return gets unattractive. Don’t know what is Real rate of interest or return? Read on…
4) Real Rate of Interest/Return
It is the actual rise or fall in purchasing/spending power each year. The crude formula is.
Real Rate of Interest = Government Rate – Inflation Rate
Suppose in India the interest on AAA rated Government security is 8%. The inflation rate is 7%. Then the real rate of interest in India is just 1%.
To consider another example, if you earn 11% interest in Germany when inflation rate is 4%, then actual real gain left is 7%. Some 1% drop in real rate might cause cautious fund managers to move their money to another country where it earns higher.
Once money starts flowing out from a country, the currency weakens as more of it is sold. It is likely to get devalued until the selling continues.
Suggested: FAQ on Currency trading here.
5) Balance of Trade
It is how much the country takes in form of selling goods as exports to how much it buys as imports. Defined roughly for your easyu understanding.
Balance of Trade = Cost of Exports – Cost of Imports
If a country exports less than it imports, then it has negative balance of trade. The higher negative, the greater disadvantage to a nation. This means too much of its currency is flowing out.India imports lot of crude oil and Gold which affect its balance of trade.
Note: A better approach would be considering the balance of payments which is actual cash flow rather than accounting entry term like Balance of Trade. The balance of payment more accurately affects the exchange rate of currency.
To borrow George Soros’ words “A nation with large investment capital from abroad may show big surplus in International payments even if it has a deficit in straight exchange of Goods.. This is useless to evaluate a decision. So I always look at Balance of Payments”.
A nation that has positive balance of payments will have better exchange rate with stronger currency. Another important factor affecting currency in forex market.
6) Political Climate
The next important or probably second most important factor in the list. Political climate of a country has a very significant effect on the exchange rate of its currency. A stable government may more or less be taken for granted in most major nations and hence not affect currency much.
But instability, like uprising in Sudan, overthrow of Saddam Hussein, military taking up power, break up of Euro all these have effects on respective currency.
Will you invest with someone who is a drunkard or liar? The same applies to investments in a country. Even recently, tensions between US and Russia on Ukraine issue caused stock market selling and US $ downfall due to speculation in markets.
People who control large sums of money need stability for peace of mind. The do not want to bet merely on hope that policies will be consistent and agreeable. There are more than 200 countries to invest in and succeed. Just the knowledge that change could come is enough to make a currency slide.
7) Labo(u)r situation
Labor situation is a somewhat ‘also’ factor. I hesitated to include this but did it anyway. If there is nearly full unemployment then there is likely to be no purchasing power and hence no sense to invest. This causes currency devaluation.
Similarly if there are labor strikes often, then this affects productivity. Additional a strong union work force means frequent wage increases affecting profitability of companies.
A nation with high unemployment has low inflation rate is the popular perception. Strike threats and labor unrest depress currency as investors and markets dislike uncertainty, lower productivity, and higher wages. They can all be potential blocker to foreign inflow.
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All these factors in totality affect the currency value. It is also sum of how money managers react and how they value each factor. Knowing how a currency performs is an important factor to consider during investments.
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But if you’re considering the next 5 years then it may not be much impactful. However, in short-term it is a definite game changer. A sharp devaluation in currency bring the market down in a jiffy.
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Let know your thoughts in comments below. Are there any factors we missed? What is on your list? What is your experience in forex market?. Tell us now.