Have you ever wondered who controls foreign exchange rates? Do you know what factors determine the price of a Euro, Yen or Ruble against the US Dollar? The answer is surprisingly simple in concept and yet incomprehensibly complicated in it scale. In simplistic terms the prices are determined by the fundamental economic forces of supply and demand. However, the foreign exchange market (or forex) is anything but simple. There are millions of buyers and sellers operating worldwide simultaneously, with trades taking place in almost every corner of the planet. Governments, institutional players, banks and individuals are all participants operating at multiple levels of this market. Major financial centers worldwide influence forex, even though the market itself is highly decentralized.
Major and minor global events have an impact on forex primarily in the way they influence the perception of the millions of buyers and sellers. This article explains how.
Forex traders are highly prone to speculation, which means that they operate based on their assumptions about the future impacts of an event. One good example is a change in government. Whenever an election is scheduled there is a possibility that the government in a country may change, resulting sometimes in sweeping changes in the financial policy of that country. While the new financial policy and its effects are far from certain at the time of election, the results of the election itself may be the subject of speculation! Forex traders tend to collectively influence the prices of currencies by creating an excess or shortage through their trades. If the traders perceive the anticipated policies to be favorable to the business climate, the price of the local currency usually appreciates, and vice versa. Eventually the perceived value of a country’s currency and its exchange value against the US Dollar (USD) may rise or fall due to speculation. Currencies are subjected to similar speculatory effects during other important events such as international trade agreements, signing or scrapping of treaties, war, natural disasters, any indications of political instability (such as protests), and so on.
The magnitude of an event is directly proportional to its impact on forex. Brexit, for example, has a much stronger impact on forex than an IPO in any of the EU member countries. Events differ in the volume of currency trades they impact. Smaller scale events also have an impact on forex. The unveiling of new technologies, mergers, takeovers and closures do contribute to the devaluation and appreciation of currencies. However in most of these cases the effects are too small to be newsworthy. In large economies the collective impacts of hundreds of such small events may affect forex rates by merely a fraction of a percent. In smaller economies the effects may be more pronounced. This is why forex rates fluctuate constantly, sometimes several times a day, despite no major events being reported in the news.
The USD is the reference currency for all forex trades. Practically all international trade takes place in USDs and is eventually converted into local currency. Governments have vested interests in ensuring an optimum exchange rate for their countries’ currencies against the USD. For nations which have a strong export surplus (exports exceed imports) it makes sense to devalue their currencies (up to a limit). Doing so increases short term local purchasing power and prosperity. On the other hand countries with a large trade deficit (imports exceed exports) have an interest in ensuring that their currencies are stronger against the USD so that they have to pay less for imports. Governments are major players in the forex trade and control their currency values constantly. They do so by fixing the exchange rates every day through their national banks. However this is sometimes not considered an ethical or effective practice. In some cases fixing has led to currency wars!
What all this means for you
If you are an expat and regularly send wire transfers back home or use international money transfers for any purpose, the exchange rate fluctuations do affect you and your beneficiaries. For example, if you are an expat in the UK, the net value of your GBPs converted into your home currency would differ pre and post Brexit. An understanding of how global events impact your currency holdings enables you to manage your finances better.