Understanding How Foreign Exchange Rates are Determined

Posted by Olympia CGP on 7/13/21 7:38 AM

If you have your eye on foreign markets, whether you want to buy and sell products, understanding how and why the value of currencies change will help you make better decisions with your money over the long term. 

For companies that need to make payments to international suppliers, or for organizations with global reach, the rate of exchange of currencies can have a major impact on their balance of payments of foreign goods and services, their purchasing power, and their overall financial health. Likewise for investors, understanding foreign exchange market fluctuations can help gain a deeper understanding of asset values and opportunities for investment. 

This short guide will begin with an overview of the modern foreign currency exchange market system and offer some insight on how foreign exchange rates are determined. 

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Understanding the Foreign Exchange Market

multiple screens showing foreign currency symbols and currency value graphs

Broadly speaking, the rate of exchange of foreign currencies fall into two categories: flexible (sometimes called a floating exchange rate) and fixed (also known as a pegged foreign exchange rate).

Flexible Foreign Exchange Rate

Because foreign exchange markets are active around the clock, five days per week, foreign exchange rates are in (near) constant flux. 

A flexible exchange rate results from the dynamics of supply and demand for that particular currency on international currency markets. Acting in a similar fashion as any other type of market, increases in overall demand drive up prices, while low demand causes prices to fall. 

Within a flexible foreign exchange system, politicians, bureaucrats and bankers avoid active intervention in the foreign exchange market, but they do make efforts to influence the rate of exchange over the long term through specific practices and policies. 

Fixed Foreign Exchange Rate 

Certain countries employ fixed exchange rates, which sets the value of the local currency in relation to a major world currency, to help ensure price certainty for imports and exports, and to keep inflation in check. 

Fixed foreign exchange rates are traditionally pegged to U.S dollars (USD), which helps central bankers keep their country’s rates within a range they deem acceptable. Those countries are able to control the value of their currencies by buying or selling their USD reserves in exchange for local currency in response to market dynamics. 

Hybrid Models

Fixed and floating exchanges are at the opposite ends of the foreign exchange market spectrum, and the truth is that few systems are entirely free floating or set in stone. Countries analyze and review their exchange rate systems all the time, and changes in government leadership often lead to changes in national economic priorities and policies. 

Governments that use a floating rate of exchange can influence rates in a number of ways, while countries with fixed exchange rate systems can employ a floating peg to help protect against inflation, for example. 

What Affects the Foreign Exchange Market?

rising arrow overlay with currency images and numbers in background

Foreign exchange rates can be affected by any number of economic or geo-political events or  developments, but market observers tend to focus on economic fundamentals, such as unemployment rates, inflation rates, gross domestic product performance and interest rates. 

The confidence of the international community in the stability of a country’s government also has a major influence on their currency price. If a country’s government lacks stability, the price of their currency is more likely to fall.   

In foreign exchange markets, the short-term movement of a particular foreign currency results not only from supply and demand but also market sentiment. Speculation and rumour have an indirect effect, as either could lead to changes in the prevailing supply and demand to cause spikes or drops. But if the movement becomes too much for central banks to bear, they can intervene to control prices, even in a floating foreign exchange system. 

Economic Factors That Affect Foreign Exchange Rates

Economic indicators are the foundation that investors use to try to understand many different types of markets, and the foreign exchange market is no different. 

Interest Rate

When a central bank sets a high interest rate, investment flows in to capitalize on the higher returns offered. This spur in demand leads to an increase in that currency’s value. 

Money Supply & Inflation

Central bankers have the difficult task of trying to manage inflation, which they do, in part, through manipulating the money supply. When there is an excess of money supply, the price of goods and services gets ratcheted up by competing consumers and inflation results. Ultimately, the over supply of currency leads to less demand and a lower value. 

Economic Growth

Investment loves growth and stability. They are why countries with strong economic growth and a stable business environment have currencies that are so attractive to investors. Strong demand keeps currency prices high. 

Understanding Exchange Rates

dollar and euro symbols with arrows pointing from one to the other

Everyone understands that the exchange rate represents how much of a particular currency will fetch in another currency, but there are other factors affecting exchange rates that make getting the best value for your money more complicated than a simple ratio. 

Foreign exchange market activity runs throughout the week, causing near-constant currency price fluctuations, however, there is a difference between the market price of a currency and the rate an individual gets when they swap currency pairs. 

Reading a Foreign Exchange Rate

The dynamics of currency pair prices are best illustrated using an example. 

If a consumer wants to trade American dollars (USD) for Canadian dollars (CAD), and they find a listing of 1.21, it will cost the consumer 1.21 CAD for 1 U.S dollar. With currency pairs, the first currency shown represents a single unit of currency (i.e. $1 CAD), while the second reflects how much of the second currency would be needed to purchase one of the first.

In this case, 1 / 1.21 = 0.8264. In other words, it would cost $0.826 USD to buy $1 CAD. 

Conversion in Practice

When an individual goes to a bank, they won’t get the same exchange rate that traders get on the market. Financial institutions charge a markup for the service of exchanging your currency. 

To refer to the previous example, if the USD/CAD market price is 1.21, a banking institution might charge 1.25 and keep the difference as their profit. 

Managing Foreign Exchange Transactions

For over-the-counter cash swaps, consumers rarely trouble themselves to find effective foreign market solutions because of the relatively small amount of currency involved. 

But for international companies, managing global payments and foreign exchange currency risk can be the source of huge savings. This is why Olympia Trust offers industry-specific currency and payment solutions for organizations of all sizes. 

Want to know more about how Olympia Trust can help boost your bottom line and simplify the world of foreign exchange rates? 

Contact Us Today for Effective Foreign Currency Exchange Solutions!



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