Exchange rates

How Are International Exchange Rates Set?

International currency exchange rates display how much one unit of a currency can be
exchanged for another currency. Currency exchange rates can be floating, in which
case they change continually based on a multitude of factors, or they can
be pegged (or fixed) to another currency, in which case they still float, but they move in
tandem with the currency to which they are pegged.

Knowing the value of a home currency in relation to different foreign currencies helps
investors to analyze assets priced in foreign dollars. For example, for a U.S. investor,
knowing the dollar to euro exchange rate is valuable when selecting European
investments. A declining U.S. dollar could increase the value of foreign investments
just as an increasing U.S. dollar value could hurt the value of your foreign investments.

Floating vs. Fixed Exchange Rates

Currency prices can be determined in two main ways: a floating rate or a fixed rate. A
floating rate is determined by the open market through supply and demand on global
currency markets. Therefore, if the demand for the currency is high, the value will
increase. If demand is low, this will drive that currency price lower. Of course, several
technical and fundamental factors will determine what people perceive is a fair
exchange rate and alter their supply and demand accordingly.

The currencies of most of the world's major economies were allowed to float freely
following the collapse of the Bretton Woods system between 1968 and
1973. Therefore; most exchange rates are not set but are determined by on-going
trading activity in the world's currency markets.

Factors That Influence Exchange Rates

Floating rates are determined by the market forces of supply and demand. How much
demand there is in relation to supply of a currency will determine that currency's value
in relation to another currency. For example, if the demand for U.S. dollars by
Europeans increases, the supply-demand relationship will cause an increase in the
price of the U.S. dollar in relation to the euro. There are countless geopolitical and
economic announcements that affect the exchange rates between two countries, but a
few of the most common include interest rate changes, unemployment rates, inflation
reports, gross domestic product numbers, manufacturing data, and commodities.

A fixed or pegged rate is determined by the government through its central bank. The
rate is set against another major world currency (such as the U.S. dollar, euro, or yen).
To maintain its exchange rate, the government will buy and sell its own currency
against the currency to which it is pegged. Some countries that choose to peg their
currencies to the U.S. dollar include China and Saudi Arabia.

Short-term moves in a floating exchange rate currency reflect speculation, rumors,

disasters, and everyday supply and demand for the currency. If supply outstrips
demand that currency will fall, and if demand outstrips supply that currency will rise.
Extreme short-term moves can result in intervention by central banks, even in a floating
rate environment. Because of this, while most major global currencies are considered
floating, central banks and governments may step in if a nation's currency becomes too
high or too low.

A currency that is too high or too low could affect the nation's economy negatively,
affecting trade and the ability to pay debts. The government or central bank will attempt
to implement measures to move their currency to a more favorable price.

Macro Factors
More macro factors also affect exchange rates. The 'Law of One Price' dictates that in
a world of international trade, the price of a good in one country should equal the price
in another. This is called purchasing price parity (PPP). If prices get out of whack, the
interest rates in a country will shift—or else the exchange rate will between currencies.
Of course, reality doesn't always follow economic theory, and due to several mitigating
factors, the law of one price does not often hold in practice. Still, interest rates and
relative prices will influence exchange rates.

Another macro factor is the geopolitical risk and the stability of a country's government.
If the government is not stable, the currency in that country is likely to fall in value
relative to more developed, stable nations.

Forex and Commodities

Generally, the more dependent a country is on a primary domestic industry, the
stronger the correlation between the national currency and the industry's commodity
prices.

There is no uniform rule for determining what commodities a given currency will be
correlated with and how strong that correlation will be. However, some currencies
provide good examples of commodity-forex relationships.
Consider that the Canadian dollar is positively correlated to the price of oil. Therefore,
as the price of oil goes up, the Canadian dollar tends to appreciate against other major
currencies. This is because Canada is a net oil exporter; when oil prices are high,
Canada tends to reap greater revenues from its oil exports giving the Canadian dollar a
boost on the foreign exchange market.

Another good example is the Australian dollar, which is positively correlated with gold.
Because Australia is one of the world's biggest gold producers, its dollar tends to move
in unison with price changes in gold bullion. Thus, when gold prices rise significantly,
the Australian dollar will also be expected to appreciate against other major currencies.

Maintaining Rates
Some countries may decide to use a pegged exchange rate that is set and maintained
artificially by the government. This rate will not fluctuate intraday and may be reset on
particular dates known as revaluation dates. Governments of emerging market
countries often do this to create stability in the value of their currencies. To keep the
pegged foreign exchange rate stable, the government of the country must hold large
reserves of the currency to which its currency is pegged to control changes in
supply and demand.

KEY TAKEAWAYS
 Fixed exchange rate regimes are set to a pre-established peg with another
currency or basket of currencies.
 A floating exchange rate is one that is determined by supply and demand on the
open market as well as macro factors.
 A floating exchange rate doesn't mean countries don't try to intervene and
manipulate their currency's price, since governments and central banks regularly
attempt to keep their currency price favorable for international trade.
 Floating exchange rates are the most common and became popular after the
failure of the gold standard and the Bretton Woods agreement.
Factors That Influence Exchange Rates
Aside from factors such as interest rates and inflation, the currency exchange rate is
one of the most important determinants of a country's relative level of economic health.
Exchange rates play a vital role in a country's level of trade, which is critical to most
every free market economy in the world. For this reason, exchange rates are among
the most watched analyzed and governmentally manipulated economic measures. But
exchange rates matter on a smaller scale as well: they impact the real return of an
investor's portfolio. Here, we look at some of the major forces behind exchange rate
movements.

Overview of Exchange Rates

Before we look at these forces, we should sketch out how exchange rate movements
affect a nation's trading relationships with other nations. A higher-valued currency
makes a country's imports less expensive and its exports more expensive in foreign
markets. A lower-valued currency makes a country's imports more expensive and its
exports less expensive in foreign markets. A higher exchange rate can be expected to
worsen a country's balance of trade, while a lower exchange rate can be expected to
improve it.

Determinants of Exchange Rates

Numerous factors determine exchange rates. Many of these factors are related to the
trading relationship between the two countries. Remember, exchange rates are
relative, and are expressed as a comparison of the currencies of two countries. The
following are some of the principal determinants of the exchange rate between two
countries. Note that these factors are in no particular order; like many aspects of
economics, the relative importance of these factors is subject to much debate.

1. Differentials in Inflation
Typically, a country with a consistently lower inflation rate exhibits a rising currency
value, as its purchasing power increases relative to other currencies. During the last
half of the 20th century, the countries with low inflation included Japan, Germany, and
Switzerland, while the U.S. and Canada achieved low inflation only later. Those
countries with higher inflation typically see depreciation in their currency about the
currencies of their trading partners. This is also usually accompanied by higher interest
rates.
 2. Differentials in Interest Rates
Interest rates, inflation, and exchange rates are all highly correlated. By manipulating
interest rates, central banks exert influence over both inflation and exchange rates, and
changing interest rates impact inflation and currency values. Higher interest rates offer
lenders in an economy a higher return relative to other countries. Therefore, higher
interest rates attract foreign capital and cause the exchange rate to rise. The impact of
higher interest rates is mitigated, however, if inflation in the country is much higher than
in others, or if additional factors serve to drive the currency down. The opposite
relationship exists for decreasing interest rates – that is, lower interest rates tend to
decrease exchange rates.

3. Current Account Deficits

The current account is the balance of trade between a country and its trading partners,
reflecting all payments between countries for goods, services, interest, and dividends.
A deficit in the current account shows the country is spending more on foreign trade
than it is earning, and that it is borrowing capital from foreign sources to make up the
deficit. In other words, the country requires more foreign currency than it receives
through sales of exports, and it supplies more of its own currency than foreigners
demand for its products. The excess demand for foreign currency lowers the country's
exchange rate until domestic goods and services are cheap enough for foreigners, and
foreign assets are too expensive to generate sales for domestic interests.

4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects
and governmental funding. While such activity stimulates the domestic economy,
nations with large public deficits and debts are less attractive to foreign investors. A
large debt encourages inflation, and if inflation is high, the debt will be serviced and
ultimately paid off with cheaper real dollars in the future.

In the worst case scenario, a government may print money to pay part of a large debt,
but increasing the money supply inevitably causes inflation. Moreover, if a government
is not able to service its deficit through domestic means (selling domestic bonds,
increasing the money supply), then it must increase the supply of securities for sale to
foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to
foreigners if they believe the country risks defaulting on its obligations. Foreigners will
be less willing to own securities denominated in that currency if the risk of default is
great. For this reason, the country's debt rating (as determined by Moody's or Standard
& Poor's, for example) is a crucial determinant of its exchange rate.

5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current
accounts and the balance of payments. If the price of a country's exports rises by a
greater rate than that of its imports, its terms of trade have favorably improved.
Increasing terms of trade shows' greater demand for the country's exports. This, in
turn, results in rising revenues from exports, which provides increased demand for the
country's currency (and an increase in the currency's value). If the price of exports
rises by a smaller rate than that of its imports, the currency's value will decrease in
relation to its trading partners.

6. Strong Economic Performance

Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive attributes will
draw investment funds away from other countries perceived to have more political and
economic risk. Political turmoil, for example, can cause a loss of confidence in a
currency and a movement of capital to the currencies of more stable countries.

The Bottom Line

The exchange rate of the currency in which a portfolio holds the bulk of its investments
determines that portfolio's real return. A declining exchange rate obviously decreases
the purchasing power of income and capital gains derived from any returns. Moreover,
the exchange rate influences other income factors such as interest rates, inflation and
even capital gains from domestic securities. While exchange rates are determined by
numerous complex factors that often leave even the most experienced economists
flummoxed, investors should still have some understanding of how currency values and
exchange rates play an important role in the rate of return on their investments.

KEY TAKEAWAYS
 Aside from factors such as interest rates and inflation, the currency exchange
rate is one of the most important determinants of a country's relative level of
economic health.
 A higher-valued currency makes a country's imports less expensive and
its exports more expensive in foreign markets.
 Exchange rates are relative and are expressed as a comparison of the
currencies of two countries.