What Affects Prices of Forex Currency Pairs?

The forex market is a dynamic atmosphere that considers various factors when pricing currencies. Not much goes unnoticed by forex traders, as everything from interest rates to the flow of foreign capital are “priced-in” to each FX pair. 

Read on to learn more about how a country’s currency is priced and how you can profit from the exchange rate volatility.

factors affecting exchange rates

What Are Exchange Rates?

An exchange rate is the value of one currency relative to another. In other words, an exchange rate is a price at which one currency may be purchased using another money.

Exchange rates come in two types: fixed and floating. Fixed exchange rates occur when a form of money is “pegged” to the value of a hard asset or another currency. A floating exchange rate is when a currency’s value is left to open market forces.

If you’ve ever traveled abroad, then you’re aware of exchange rates. Let’s say that you live in the United Kingdom and go on holiday to the United States. At some point, you will have to trade your British pounds for U.S. dollars. The foreign currency exchange rate will determine how many USDs you receive for your GBPs. 

If the GBP/USD exchange rate is greater than 1, you will receive fewer USDs than your GBP; if greater than 1, you will receive more USDs. It’s as simple as that!

GBPUSD forex chart exchange rate

What Determines Exchange Rates? 

Exchange rates are constantly fluctuating in response to ever-evolving market forces. And, like all other assets, the supply & demand relationship plays a primary role in determining FX exchange rates.

Generally, as the demand for a country’s currency increases, supplies dwindle, and it appreciates. However, the currency supply/demand curve is unique from other asset classes. Exchange rates hinge on three factors: economic performance, monetary policy, and foreign exchange market sentiment.

Economic performance

The economic health of a country or region is vital to the valuation of its currency. For instance, a solid gross domestic product (GDP), positive trade balance (imports vs. exports), and low sovereign debt may contribute to a rising currency value.

On the other hand, heavy debt, economic contraction, and high unemployment levels signal that something may be amiss. Given these fundamentals, it isn’t out of the ordinary for a domestic currency to depreciate.

economic growth, economic performance, fed

Monetary Policy

By far, the most significant drivers of exchange rates are central banks. Any policy shift — be it dovish or hawkish — can bring about significant changes in currency pricing.

The primary mission of any central bank is to promote pricing stability, maximum employment, and economic growth. Central banking authorities intervene to control the money supply to accomplish this goal. This is done in three ways:

  1. Hike or cut interest rates
  2. Extend or restrict the flow of credit
  3. Conduct debt purchases or sales (open market operations)

Each of these activities directly affects the money supply of a nation or region. For example, when the Bank of England (BoE) raises the prime interest rate, people are incentivized to deposit their GBPs. Subsequently, the GBP exchange rate is positioned to gain value against other foreign currencies.

Below is a quick look at how central banking policies can impact a domestic currency:

  • Rate Hike: Higher interest rates promote currency strength by reducing the money supply.
  • Rate Cut: Rate cuts lessen a currency’s value by increasing the money supply.
  • Quantitative Tightening: Lending restrictions and reduced open market operations reduce the supply of money, thus strengthening currency value. 

Quantitative Easing: Enhancing lending and open market operations increases the money supply and decrease currency value.

monetary policy forex

Foreign Exchange Market Sentiment

Market sentiment is the collective attitude of traders and forex market participants towards security, product, or a particular market. Think of sentiment as the public’s disposition; it can be bullish, bearish, or neutral.

It’s important to understand that many factors play into forex market sentiment, thus influencing exchange rates. Aside from the two listed above (monetary policy, economic performance), a vast number of events can quickly sway sentiment. Examples are politics, armed conflict, trade wars, or foreign capital investiture.

The relationship between FX sentiment and a country’s exchange rate is straightforward:

  • When sentiment is positive (bullish) toward a currency, its value appreciates against foreign currencies.
  • When sentiment is negative (bearish) toward a currency, its value depreciates against other currencies.
  • When sentiment is neutral, the value of a currency remains the same.

The critical thing to remember about forex sentiment is this: it is often a precursor for strong trends. When sentiment toward a currency or currency pair is strong, be wary of bullish and bearish trends!

Exchange Rate Case Study: EUR/USD

Sometimes, the best way to learn is to study a real-world example. Let’s dig into the EUR/USD and take a look at the exchange rate, price action, and valuation.

The Exchange Rate

First things first. In forex, exchange rates are represented by comparing a base currency to a counter currency. The base currency is listed first, and the counter currency is second.

EURUSD exchange rate, forex

In the case of the EUR/USD, the euro (EUR) is the base currency, and the U.S. dollar (USD) is the counter currency. Thus, the exchange rate is the number of euros you will get for a USD. 

Price Action

As an asset undergoes the process of price discovery, its value changes. This evolution can be due to any number of factors but results from an imbalance of buyers and sellers. When there are more buyers than sellers, an exchange rate goes up; if sellers outnumber buyers, rates go down. 

In the case of the EUR/USD, the price rises when bidders take control of the market. Given this scenario, the EUR rallies or gains value against the USD.

On the other hand, when the EUR/USD falls, sellers have control of the market. Thus, the USD gains value versus the euro when the EUR/USD trends south.

EURUSD forex chart exchange rate

How to make money trading currency exchange rates

No matter your strategy, there are only three ways to make money trading exchange rates. They are as follows: buy low/sell high, sell high/buy low, or do neither. 

Buy low, sell high

If you have a bullish bias toward an exchange rate such as the EUR/USD, you will buy the pair. In doing so, you will open a new “long” position in the market and profit from rising prices. Thus, you buy a currency pair to profit from bullish price action.

Sell high, buy low

One of the best things about the forex is that traders can make money from both rising and falling exchange rates. To profit from bearish price action, you sell a currency pair.

When in doubt, stay out!

In the forex, it’s often not what you do but what you don’t do that makes you successful. After all, we don’t take trades for the sake of taking trades — the goal is to profit from putting our capital in harm’s way!

If we are confused by price action or don’t have an opinion on a currency pair, staying out of the market is a good idea. Remember, when in doubt, stay out!

Summary

An exchange rate is a price at which one country’s currency may be swapped for another. Many market drivers can impact foreign currency exchange rates, such as central bank policies, interest rate hikes or cuts, FX market sentiment, and economic performance.

One of the best things about forex trading is that we get to do it on our terms! We can make money from buying or selling or staying out of the market altogether. And, if we are competent, our own currency reserves grow while the competition dwindles.

Now that you know all about exchange rates, on to the next lesson!