Currency traders trade currencies a lot on daily basis. But most currency traders lack an understanding of how exchange rates are determined and what role they play in an economy. In the modern world economy, exchange rates are simply unavoidable. Whatever the subject, exchange rates crop in. Talk about the domestic economy, stock market, upcoming elections, exchange rate discussion will suddenly appear.
Today around $4 trillion is being traded on a daily basis in foreign currencies across the world. Globalization is taking place at a rapid place. National economies are getting more and more integrated into the global economic system. International trade is becoming more important as compared to domestic trade. When you talk of international trade, exchange rates crop in. Exchange rates are high volatile and unpredictable and have the potential to turn a profitable deal into a loss maker. If you are taking a foreign trip, exchange rate fluctuations can skyrocket your holiday budget. Did you read the post on how to use Brownian Motion in trading?
It is important for you as a currency trader to know why exchange rates change and the economic rationale behind the change. You should also know why it is very difficult to predict exchange rates. It is already clear to you as a trader that it is very difficult to accuracy predict the currency price but you should know the reasons why it is such a difficult task. Now it is also important for you to know how to hedge exchange rate risk if you are a business manager. How to evaluate and understand the comments made in the financial media on exchange rates and the comments made by your broker on exchange rate movements in the newsletter as well as the comments made by the politicians and bankers on exchange rates. This is very important for you to understand. Read the post on how to code candlestick patterns in MQL5. So let’s start!
Exchanges rates are nothing other than that price at which we exchange currency A which can be USD with currency B which can be EURO. So EURUSD is the exchange rate at which we will exchange EUROs for 1 USD which right now is 1.13137. So right now if we have 1 USD we can exchange it for 1.13137 EUROs. In the same manner, if you have 1 EURO, you can exchange it for 0.88 USD or 88 cents. You can think of the exchange rate as the price of the foreign currency in terms of the domestic currency. Suppose on day, you find British Pound (GBP) fallen in value as compared to USD meaning GBP has depreciated against USD. What has happened? Does this mean GBP has fallen value or USD has risen in value. Both these effects will make GBPUSD exchange rate fall. So we need to investigate more.
If GBPUSD fell due to the USD rise in strength, we need to look towards the US economy to clues. And if GBPUSD fell due to GBP falling in value, we need to look towards what is happening in the UK economy right now. Brexit is putting a lot of pressure on GBP so obviously GBP is falling in value rather than USD gaining strength. You can understand it better with the analogy of milk. Price of milk increases in the market. This can be due to the increase in the relative price of milk in the market. Or it can also be due to the general rise in the prices of household goods due to the rise in inflation in the economy. If this is true and the price of milk has increased due to inflation we say value of domestic currency has fallen. Read the post on how to use fuzzy logic in trading.
So if the price of GBP has fallen relative to USD while the price of GBP relative to EURO and YEN and AUD and NZD has not changed, it means USD has strengthened. On the other hand, if GBP has fallen in value relative to USD, EUR, JPY, AUD, NZD and else, we say GBP has fallen in value. So how do we know what has happened? We can take a look at EURUSD and GBPEUR rates. Now we can think of the domestic economy and the rest of the world economy. We can measure the strength/weakness of the domestic currency based on a weighted index of exchange rates with a host of other foreign currencies. This is precisely what we get with the USD Index which is the value of USD measured relative to a basket of foreign currencies that includes EUR, GBP, JPY, CHF, CAD and SEK.
Now you should be familiar with the bid/ask spread. There are intermediaries in the currency market who make a profit by providing liquidity to the market when they take the opposite position to the buy order and similarly opposite position to the sell order. This spread is what we traders pay when we open and close a trade. Heavily traded currencies like USD, EUR, JPY, GBP etc have low spreads as compared to thinly traded traded currencies like PKR where the spread can be high. Let’s return to the most important question that we want answered.
What Determines Exchange Rates?
How can we explain the wild fluctuations in the exchange rates of EURUSD, GBPUSD, USDJPY etc that we see on daily basis? If you have study microeconomics you might know what determines the price of a good or service? Suppy and demand. Yes exchange rates are also prices and are determined in the market by the forces of supply and demand. When the demand for USD is high in the market, its price will go up. In the same manner, when the demand for GBP is low in the market, its price will go down. You might be wondering what creates the supply and demand for exchange rates in the market. Let’s discuss it.
Export of good and services from the domestic country is the source that creates supply of foreign currency. Let’s suppose we are exporting from UK to US. We are earning USD and supplying these US Dollars to the UK economy. On the other hand when we are importing US goods and services we are creating the demand for US Dollars which will be paid by the US Dollars that we earned by exporting goods and services to US. Foreign investors also want to buy property in London. So they want British Pound (GBP) for buying the property. So foreign investors are also creating a demand for the domestic currency GBP. In the same manner, UK investors want to invest in foreign lands and if that is US, they will need USD. This will create a demand for USD. Download Top Shelf Trading Magazine free.
There is a third type of player in the currency market active also. They are known as speculators. Yes, we currency traders are speculators who want to profit from the fluctuating supply and demand in the foreign exchange market. Speculation is done by buying and selling on short term instruments dominated in USD and GBP to profit from their exchange rate fluctuation. Now truth be told we retail currency traders are small fish in the market. Actual speculators are the big banks, hedge funds and other players who have deep pockets. These people have the resources to influence the exchange rate in the short term. So basically these are the players active in the currency market: exporters, importers, investors and speculators. Just keep this in mind investment is always long term while speculation is always short term. Learn these candlestick patterns tricks.
When USD is cheaper than GBP, there will be more imports from US and when GBP is cheaper than USD, there will be more exports to US. This is obvious when the USD is cheaper and GBP is expensive, a good produced in UK will need more US Dollar while a good produced in US will require less US Dollar so there will be more demand for US good and less demand for UK goods which will result in more demand for USD and less demand for GBP. In the same manner with GBP expensive, US investors will have to pay more US Dollars to buy property in London. So most will not do that as it will be expensive for them. On the other hand, UK investors will now find US property to be cheap and less expensive so there will be more demand for USD and less demand for GBP. Learn how to trade EURUSD naked.
So whenever USD is cheap and GBP is expensive, USD demand will be high while its supply will be less. In the same manner, when USD is expensive and GBP is cheap, USD demand will be low and supply will be high. At some price the supply and demand will equal which will determine the exchange rate for that moment. So this is how high supply and demand determines the exchange rates in the currency market. Now this will be a surprise for you. Modern currency market is being controlled by the speculators ( I mean speculators with big pockets). What this means is that we can talk of net demand versus net supply when analyzing a particular exchange rate.
Now this is a true fact. Modern currency market is dominated by speculators who swamp all other players in the market like the importers and exporters and hedgers. Banks and other financial institutions have their trading desks that daily trade their portfolios comprising hundreds of millions of dollars. So when dealing with the currency market, we should talk about excess demand in the market instead of the traditional supply and demand. Most of the time we will be talking about the excess demand and the slope of the excess demand curve.