The Value of a Currency
What makes a currency strong? The value of a currency, like any other asset, is determined by supply and demand. An increase in demand for a particular currency will increase the value of the currency, while an increase in supply will decrease the currency’s value.
The exchange rate is the value of one country’s currency in relation to another. For example, if USD/JPY is trading at 130, then one US dollar will be exchanged for 130 yen. Exchange rates are determined in the foreign exchange markets and are constantly fluctuating.
What determines the value of a currency? Let’s examine some key factors which are important to review in order to trade forex in a smarter way.
Interest rates are one of the most important determinants of exchange rates. When the country of a certain currency offers higher interest rates, the value of the currency value will rise, since investors, who are looking for the best rate they can find, can earn a higher return relative to other currencies.
Higher interest rates will attract foreign capital, and as the currency is in higher demand, its value will increase. Conversely, if a country lowers interest rates, the currency value of that country will decrease. Suppose the US Federal Reserve raises interest rates. This makes the US dollar more attractive, because investors will receive higher interest on their US dollar deposits. As more investors purchase US dollars (with other currencies), the value of the dollar will rise.
Inflation is the overall rise in the price of goods and services. If inflation rises, it results in a decrease in money’s buying power. Generally speaking, countries with consistently low inflation rates will have currencies that have a higher value than currencies of countries with high inflation.
A useful rule of thumb is that inflation and interest rates have an inverse relationship. Higher inflation will decrease the value of a currency, while higher interest rates will increase its value. Conversely, lower inflation will boost the value of a currency, but lower interest rates makes a currency less attractive to investors and hence lowers its value.
Investors looking to invest their assets are seeking safety and certainty. A country with a strong economy will be deemed an attractive location for investment. How do we determine what is a strong economy? This can be determined by a host of economic indicators, such as GDP, unemployment and debt.
Gross Domestic Product (GDP) is the total value of the goods and services produced by the economy. When a country’s GDP rises, it means that the economy is expanding. Investors are looking to put their assets in countries with high GDP growth rates. Conversely, a drop in GDP indicates that the economy is in decline, which could result in a decrease in investment.
Low unemployment is an important indicator of a strong economy, which will increase the demand for that country’s currency. If unemployment is on the rise, it is reflective of a weaker economy, and the demand for the currency may drop, resulting in a lower exchange rate. If, for example, the UK released an employment report that showed unemployment had dropped compared to the previous unemployment report, this would be a positive development and would likely send the British pound higher.
Nations with large public debts are less attractive to foreign investors. Large debts often result in higher inflation, especially if a government prints more money in order to help pay for the debt. As well, investors may be concerned that the government might default on its obligations. This is the reason that a country’s debt rating is an important factor in the exchange rate – the higher the debt rating, the more likely that the country can pay back its debt, which will make the country more attractive to foreign investment and increase the value of the currency.
In addition to the economic factors listed above, Investors tend to look for countries which offer political stability in which to invest their capital. Political turmoil can result in a loss of confidence in a currency and lead to a flow of capital towards currencies of countries that are considered more stable.
A major political development could also cause a currency to fluctuate. If, for example, the UK and the European Union were to announce that they had reached a post-Brexit agreement, this would increase confidence in the UK and eurozone economies, and both the euro and the British pound would likely rise against the US dollar.
Safe Haven Status
In times of market turbulence, investors who are looking to reduce their risk will seek assets that act as “safe havens” until the market steadies and investors are ready to take on more risk. The US dollar, Swiss franc and the Japanese yen are all considered safe-haven currencies. These currencies have shown over time that they retain (or increase) their value during times of economic uncertainty, and investors will purchase safe haven currencies and sell currencies which are more sensitive to risk, thus increasing the value of the safe-havens.
Trading Fluctuating Currencies
The forex market is made up of currency pairs, which are constantly fluctuating in value. The value of a currency - reflects how strong the currency is in comparison to another currency. To improve your forex trading performance, you must first understand the factors that influence the value of a currency.
Skill can be acquired. There are numerous online resources available for beginners to gain knowledge and know-how when it comes to forex trading.
With the best trading platforms practice is also available through an online demo. Start with a practice account and simulate trades before going live and risking your money. Apply for a demo here.
This article is for general information purposes only, not to be considered a recommendation or financial advice. Past performance is not indicative of future results.
It is not investment advice or a solution to buy or sell instruments. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading in foreign currency contracts or other off-exchange products on margin carries a high level of risk and may not be suitable for everyone. We advise you to carefully consider whether trading is appropriate for you in light of your personal circumstances. You may lose more than you invest. We recommend that you seek independent financial advice and ensure you fully understand the risks involved before trading. Trading through an online platform carries additional risks. Losses can exceed deposits.