Articles

Factors Affecting Exchange Rates

Similar to any other financial price, the price of an exchange rate is determined by the forces of demand and supply. The price of an exchange rate reflects many economic and non-economic factors. The most important factors are interest rates, inflation, growth, employment, and political risk.

Here are all the major factors affecting the fluctuations of global currencies.

1. Interest Rates

Central Banks and Interest Rates

The interest rates of an economy are adjusted by the domestic monetary authority, such as the FED in the US and the ECB in the Eurozone. When the interest rates of a particular currency increase, more investment funds are attracted and buy that currency to achieve a higher interest return. On the other hand, when interest rates are decreasing an exchange rate is less attractive to investment funds and thus it is expected to fall against other currencies.

Interest Rates Correlations

1) Interest Rates increase ↑ → market liquidity and inflation are expected to decrease ↓ → the domestic exchange rate increases ↑

2) Interest Rates decrease ↓ → market liquidity and inflation are expected to increase ↑ → the domestic exchange rate decreases ↓

THE HISTORY OF MONETARY EMPIRES (ACCORDING TO RAY DALIO)

The legendary hedge fund manager Ray Dalio offers an insight into the dynamics that he saw when studying the rises and declines of the last three reserve currency empires (the Dutch, the British, and the American) and the six other significant empires (Germany, France, Russia, India, Japan, and China) over the last 500 years.

Monetary Patterns & Key Findings

After studying these past cases, he has identified clear patterns that occurred for logical reasons:

1. Behind the success and failure of great monetary empires, over time, there are giant cycles

2. 17 forces affect the big cyclical swings in wealth and power (check below)

3. Of the 17 forces, the debt cycle, the money and credit cycle, the wealth gap cycle, and the global geopolitical cycle are the most important to understand

The Foreign Exchange market is a global decentralized market for the trading of global currencies. Forex brokers provide access to the Foreign exchange market by linking retail and institutional capital to the liquidity of the ECN network of banks.

Understanding the Categories of Forex Brokers

There are two general categories of financial firms offering access to the Foreign Exchange market:

• No-Dealing-Desk Firms (ECN/STP Brokers)

This type of financial broker is electronically connected to the ECN network of banks or the Electronic Communications Network. That means they offer fast trading with low slippage and very tight trading spreads.

□ ECN brokers give their clients direct access to the ECN market; these are usually very large firms.

□ STP brokers route their client orders electronically to a liquidity provider. 

□ Neither ECN nor STP brokers involve human intervention as they pass their clients' orders directly into the global currency market. This is why they are called NDD brokers (No-Dealing-Desk).

UNDERSTANDING MARKET SENTIMENT

Market sentiment refers to the prevailing attitude of investors in a particular market.

■ Always Consider Whether Your Idea is Already Discounted by the Market

You must always consider whether the market has already discounted your trading idea. If your idea is based on news, consider that at least 90% of news is already incorporated in the prices.

Michael Marcus says that you must always ask yourself: "How many people are left to act on this particular idea? -You can evaluate that by using the classic momentum-type indicators and observing the market tone. How many days has the market been down or up in a row? What is the reading on the sentiment indexes?”