To more fully understand how the value of foreign currency investments is measured, it is important to have a clear picture of what an exchange rate is, and how it functions.
An exchange rate is the price at which one country’s currency may be exchanged for another.
If you have ever traveled outside of your home country, let’s say from the U.S. to Switzerland, you likely had to go to a currency exchange to convert your U.S. dollars to Swiss francs.
Let’s say you hand the exchange 100 U.S. dollars, and not taking into account any service fees or other charges, you receive 91.50 worth of Swiss francs in return. As spending in Switzerland can be somewhat costly, you quickly run out of francs and go back to the exchange the next day with another 100 U.S. dollars that you want to turn into local currency. This time, however, you’re given 91.46 worth of Swiss francs in return.
If you’ve never exchanged currencies before, you may ask the operator of the exchange why you got less than the day before. You think there may be some mistake.
The operator will then likely explain to you that, no, there was no error. In fact, most advanced nations have a floating exchange rate, or spot rate, meaning the value of their currencies aren’t fixed, but rather fluctuate relative to other currencies.
Remember, as an investor of foreign exchange, what you surrender is one nation’s currency for another – and you do so at an agreed upon exchange rate based on the activity of many buyers and sellers of currencies, and established in the interbank market.
FX Rate Drivers
So, what are some of the factors that influence the supply and demand dynamics for a certain country’s currency and that hold sway over its spot rate?
There can be several – including:
- A country’s trade balance,
- The level of demand for its goods and services,
- Its foreign investment activity,
- Its political climate,
- Is there a surge in volatility or unrest?
- Is it engaged in a war?
- What percent of its population may be considered affluent?
Monetary and Fiscal Policies
Also, while central banks are typically independent, government policy often sets out goals for employment and growth. And while the central bank often has a mandate to set interest rates with an inflation objective in mind, they have no control over those political objectives that aim to drive growth or impact trade flows.
As an investor analyzing the currency market, you would likely want to examine, among other factors, that country’s fiscal and monetary policies.
By doing so, you may find you have greater conviction in some governments more than others, and that certain central banks have a better reputation than others.
Often, one currency unit’s health is controlled by investors’ beliefs in the bias of its central bank and often by the belief that the central bank will follow through on its words with action.
Many in the market, for example, may focus on the monetary policies of the U.S Federal Reserve and the effectiveness of its dual mandate to promote maximum employment and price stability – this with an eye on the inverse relationship between a foreign currency and the U.S. dollar, where a strong dollar signals weakness in the foreign currency unit, and a weak dollar indicates foreign currency strength.
Others may look to the euro, a product of several individual European nations, which formerly held their own currencies. The euro, a single-currency system, was primarily adopted to help reduce currency risk among those participating nations, as well as to facilitate the movement of capital, goods and services between them.
As an investor of foreign currencies and the euro, you may want to look closely at the Eurosystem, which is comprised of several national central banks and the European Central Bank, or ECB – which was created in large part to implement monetary policy and conduct foreign exchange operations.
Overall, however, trading in the forex market is an inexact science and can often produce significant intraday price shifts, as there is no proven formula to determine the strengthening or weakening of an exchange rate relative to any other unit.
Disclosure: Interactive Brokers
The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Interactive Brokers LLC, its affiliates, or its employees.
There is a substantial risk of loss in foreign exchange trading. The settlement date of foreign exchange trades can vary due to time zone differences and bank holidays. When trading across foreign exchange markets, this may necessitate borrowing funds to settle foreign exchange trades. The interest rate on borrowed funds must be considered when computing the cost of trades across multiple markets.