Factors Influencing Foreign Exchange Rates

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Besides factors like inflation and interest rates, the foreign exchange rate is one of the most significant determinants of any country’s comparative degree of economic health. The foreign exchange rate plays a key role in any country’s trade level, and this is vital in nearly every free economy around the world today. For this reason, the foreign exchange rate is closely watched and analysed daily.

Exchange rates count on a global level, but they also count on a smaller scale. They are one factor that affects the returns in an investor’s portfolio. Since you know how important the foreign exchange rate is, you should also know the factors that influence it.

Additional Read: what is Foreign Portfolio Investment?

What is a Foreign Exchange Rate?

Rates of exchange can change, and these changes affect many aspects of economic life, both on an international level and a domestic level. Before you know what factors affect the foreign exchange rate, you should have a good idea of what it entails.

The foreign exchange rate is the rate at which a currency is exchanged. The foreign exchange rate is also called the forex rate. For instance, the rate of exchange of 1 USD to the Indian Rupee is ₹83.31. This means that the Indian Rupee trades at ₹83.31 to 1 USD. Among interested parties in the financial world and economic markets watching the foreign exchange rate, governments keep a close eye on the rate as well, taking any necessary measures to maintain the rate at an advantageous level relative to the country’s fiscal health.

Additional Read: Global Market

Factors Influencing the Foreign Exchange Rate

There are specific factors that influence the foreign exchange rate which may change according to a corresponding fluctuation in any one or more factors. Here are the key factors that influence the foreign exchange rate:

Inflation

Inflation is, perhaps, the crux of why rates of exchange can undergo volatility. When a country has a low rate of inflation, the value of its currency tends to go up. This is because the purchasing power of the country relative to other countries rises. On the other hand, high rates of inflation indicate that the country’s purchasing power drops and its currency depreciates relative to other currencies.

Rates of Interest

The interest rate in a country can influence its foreign exchange rate. In a country with high interest rates, lenders have the opportunity to earn more. This draws foreign capital that is seeking the earning of higher interest rates. Consequently, the country’s foreign exchange rate goes up, and the country’s currency gains strength.

Interest rates can be directly linked to inflation as well. A country’s central bank can influence exchange rates or inflation through the channel of interest rates. High rates of interest imply a high cost of borrowing. It is possible to discover that despite a rise in interest rates, inflation does not appear to decrease. In contrast, deflated interest rates may bring down the foreign exchange rate.

A Country’s Deficit

If the country is facing a current account deficit, then it indicates that the country is spending more to purchase goods and services relative to what it earns. As a result of this, the earnings in foreign exchange through exports may not be sufficient. The country may end up borrowing capital from overseas to make up for its loss. This demand for foreign currency can bring down the country’s foreign exchange rate.

A Country’s Debt

Any country may engage in domestic and international projects, say infrastructure projects, and end up borrowing funds to meet the financial requirements for these. Borrowing may be at a domestic or an international level. The projects that the country is developing may economically benefit the country in the long run, but the public debt they cause may lead to high inflation. Therefore, the foreign exchange rate becomes weak.

Imports and Exports

When a country exports goods or services, it earns money. When it imports goods and services, it spends money. If the exports of a country are higher than its imports, then there is a demand for goods and services that other countries are willing to pay for. This brings a stream of wealth into the country and the foreign exchange sees a hike in such a positive economic environment. Conversely, the foreign exchange rate may plunge if imports are more than exports.

The Final Word

The foreign exchange rate of the currency of the bulk of any investments in a financial portfolio sheds light on the real returns of investment in that portfolio. If an exchange rate goes up, it clearly indicates the strength of a country’s economy as many factors that determine the economic health of a country influence the rate of foreign exchange.

Foreign exchange rates are determined by several factors, and these may not just be economic in nature. For instance, events like natural disasters and wars can be detrimental to any country’s economy and plunge foreign exchange rates into an abyss. However, the key factors that bring rates down are largely economic, and investors should know about these while mitigating risk in their investments. 

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

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