Currency values play a vital role in international finance, trade, and the global economy.
Naturally, the fluctuating nature of currency values is what allows currency traders to generate profits.
To make informed decisions and succeed in foreign exchange trading, it’s important to understand the factors that give a currency its value and the mechanics behind why they move.
This article will look at the concept of currency valuation, the factors that contribute to it, and how these factors can be used to make educated trading decisions.
Key Takeaways – What Gives a Currency Value?
- Currency values are crucial in international finance, trade, and the global economy, impacting competitiveness, imports, exports, and investments.
- The fluctuating nature of currency values allows currency traders to profit by buying and selling currencies based on price movements.
- To make informed trading decisions, understanding the factors influencing currency values, such as supply and demand, interest rates, economic indicators, political stability, and market speculation, is essential.
Supply and Demand
At a super basic level, a currency value is primarily determined by the laws of supply and demand.
When there is high demand for a currency, its value increases; conversely, when demand is low, its value decreases.
Similarly, if there is an excess of supply, the currency’s value will decrease, and if the supply is limited, the value will increase.
Of course, we need to explore what influences supply and demand and how.
Factors that can influence the supply and demand of a currency include, most prominently, interest rates, economic indicators, political stability, and market speculation.
Let’s look at each of these.
When a currency pays more in interest (cash and assets denominated in the currency, such as bonds), it increases the demand for it, all else equal.
Central banks’ role
Central banks play a role in influencing currency value by setting short-term interest rates (i.e., essentially cash rates).
They can also have an influence on long-term rates via their open market operations like QE.
When interest rates are high, it attracts foreign capital who want to exchange their money for the higher-interest currency, resulting in increased demand for the currency and therefore an appreciation in its value.
Conversely, low interest rates can lead to a depreciation in the currency’s value.
Currency traders can take advantage of interest rate differentials between countries by engaging in carry trades.
By borrowing in a low-interest-rate currency and investing in a high-interest-rate currency, traders can profit from the difference in interest rates.
These trades cease to become profitable when the high-interest-rate currency depreciates relative to the low-interest-rate currency by more than the interest rate differential.
For example, if one is long a 6% interest currency and short a 2% interest currency, the carry is 4% (the interest earned on it per year).
When the depreciation is greater than that, trade will lose money.
It’s analogous to a 4% dividend stock depreciating by more than 4% in a one-year period.
Gross Domestic Product (GDP)
GDP is an indicator of a country’s economic health, measuring goods and services sold.
A strong GDP signals a robust economy, which can attract foreign investment and increase demand for the currency.
Inflation erodes purchasing power and affects the value of a currency. When a country has a high inflation rate, it can lead to depreciation of its currency.
Policymakers, if they wish to keep their currency at least steady, need to provide an interest rate that compensates traders/investors for the sum of the inflation rate and any depreciation pressure on the currency as a result of the underlying capital flow.
This creates a two-way market.
Employment data, such as the unemployment rate, can impact currency value.
High unemployment rates can indicate a weak economy and the need to lower interest rates, which may result in decreased demand for the currency.
A fiscal deficit occurs when a government spends more money than it earns. This leads to increased borrowing, which can increase interest rates and inflation if there isn’t the demand for these bonds.
Investors may lose confidence in the currency, leading to its devaluation.
Overall, a fiscal deficit can negatively impact the value of a currency, especially when it leads to borrowing that isn’t wanted by the free market.
Current Account Deficit/Surplus
A current account deficit occurs when a country imports more goods and services than it exports, while a surplus means the opposite.
A deficit can lead to increased demand for foreign currency, causing depreciation, while a surplus can strengthen the currency due to increased demand for domestic currency.
Related: Creditor Surplus Countries vs. Debtor Deficit Countries
Importance of stability
Political stability can significantly impact a currency’s value. It is especially a factor in many emerging markets.
Stable governments with sound fiscal policies tend to have stronger currencies, as they are perceived as safer investments.
Impact of political events
Political events such as elections, referendums, or geopolitical tensions can lead to wider distributions of expected outcomes and affect currency values.
Market speculation can greatly influence currency value.
Traders’ expectations and sentiments can drive demand for or against a particular currency, causing it to appreciate or depreciate.
The price of anything is simply the money and credit spent on it divided by the quantity.
While in the long-run what we mentioned above are the biggest drivers, in the short-run speculation can matter a lot.
FAQs – What Gives a Currency Value?
How does a country’s trade balance affect its currency value?
A country’s trade balance, which is the difference between its exports and imports, can impact its currency value.
A trade surplus (when exports exceed imports) typically leads to an appreciation in the currency value, as foreign demand for the country’s goods and services increases.
Conversely, a trade deficit (when imports exceed exports) can cause the currency to depreciate, as the demand for foreign currencies to pay for imports increases.
Can central banks intervene directly in the foreign exchange market to influence currency values?
Yes, central banks can directly intervene in the foreign exchange market to influence currency values.
They can do this by buying or selling their own currency (via FX reserves, a form of savings) in exchange for foreign currencies.
This process, commonly known as foreign exchange intervention, can either support their domestic currency (by buying it) or weaken it (by selling it) to achieve specific economic objectives, such as controlling inflation or promoting export competitiveness.
How do exchange rate regimes impact currency values?
Exchange rate regimes, which refer to how a country manages its currency in relation to other currencies, can have a significant impact on currency values.
There are three primary types of exchange rate regimes: floating, fixed (managed), and pegged.
In a floating exchange rate regime, the currency value is determined by market forces, leading to more frequent fluctuations. Most currencies are floated freely, and most commonly in developed countries.
In a fixed exchange rate regime, the currency value is set by the government or central bank, and it is maintained at a specific level or within a tight range.
In a pegged exchange rate regime, the currency value is tied to another currency or a basket of currencies, which can provide more stability than a floating regime but still allow for some fluctuations.
Sometimes currencies are tied to a commodity like gold (and to a lesser extent silver). This has been done throughout history and was a staple of the Bretton Woods monetary system that lasted from 1944 to 1971.
What role do speculators play in currency markets, and how can this impact currency values?
Speculators are market participants who attempt to profit from short-term fluctuations in currency values by buying and selling currencies based on their expectations of future price movements.
Speculators can have a significant impact on currency values, as their trading activities can amplify price movements, creating more volatility.
This can lead to sudden and significant shifts in currency values, which can create opportunities or risks for currency traders.
How do currency values impact the global economy?
Currency values play an important role in the global economy, as they affect international trade, investment, and financial flows.
Fluctuations in currency values can alter the competitiveness of a country’s exports, the cost of imported goods and services, and the value of foreign investments.
These changes can have both positive and negative effects on economic growth, employment, and inflation in various countries.
As a result, understanding currency valuation is essential not only for currency traders but also for policymakers and businesses involved in international transactions.
Currency values play a significant role in international finance, trade, and the global economy.
Understanding the factors that influence currency values is important for making informed trading decisions. Factors such as supply and demand, interest rates, economic indicators, political stability, and market speculation all contribute to the fluctuations in currency values.
Additionally, policymakers and businesses involved in international transactions must consider currency valuation to effectively manage their operations.
For a fuller explanation of currency valuation models, please see our article here.