19 December 2019

Contextual Factors That Affect Currency Valuation

Contextual Factors That Affect Currency Valuation

Given its long-standing reputation as the world’s largest and most active financial market, it should come as little surprise that there are numerous factors that can affect how the forex market operates on a daily basis. No factor is arguably more important than changes in currency exchange rates – which, as a result, can considerably influence a forex trader’s ability to make either a profit or face a financial loss.

So, in this blog post, we’re discussing the key role that external factors from all corners of the world can play in the potential profitability and success rate of forex trades through their direct impact on currency valuation. Exploring what exactly exchange rates are and the influence political, social and economic factors have on them, we’re helping you to create a well-informed forex strategy based on real goings on in the world – as opposed to just the theory you’ve based your strategy on thus far.
 

Currency exchange rates: What are they?

Simply put, currency exchange rates are the value of one currency against another country’s (or economic zone’s) currency, and is arguably the most important determinant of a nation’s economic health.

Foreign exchange rates are known to regularly fluctuate due to a number of external factors including trade supply and demand and political instability – helping to form the most basic motive for global forex trading. While currency exchange rates are widely used to gage a feel for a country’s economic and political stability, they are also commonly used by people around the world before they travel to determine the best value for money they can expect to get for their money ahead of their holiday abroad.
 

How does inflation affect currency valuation?

Rate of inflation is the difference in the price of goods and services over a period of time. For the majority of cases, a nation that has a low inflation rate will typically have a rising currency value as a result of their purchasing power increasing relative to other nations’ currencies.

In contrast, countries that have higher inflation rates will often see their currency value depreciate in comparison to that of their trading partners. Towards the end of the 20th century, Switzerland, Germany and Japan were among the countries with the lowest rate of inflation, while the USA and Canada only achieved a low inflation rate years later in the 21st century.
 

spilled jar of coins
Photo by Josh Appel on Unsplash

 

 

How do interest rates affect currency exchange rates?

Central banks hold the ability to manipulate interest rates and, therefore, the right to exercise power over changing inflation rates and exchange rates – in turn causing a country’s currency value to alter. In layman’s terms, this means than where there is an increase in interest rate, that particular country’s currency will appreciate as a result. This is due to higher interest rates providing naturally higher rates to lenders and attracting more foreign capital, thus increasing a nation’s currency exchange rate as a result.
 

What other external factors affect currency valuation?

In the financial markets, all the world’s currencies enter transactions depending on flexible exchange rates. In turn, this means that prices for currency being bought and sold in the market change on the supply and demand of a particular currency in the currency market. For example, if there was a significant demand for a certain currency or, contrastingly, a shortage in its supply, there would be an increase in its price as a result.

Undoubtedly, this will depend on the rates of interest and the rate of inflation, however there are other external social, economic and political factors that can be seen to attribute to this difference.
 

What effect does politics have on forex?

A country’s political stability affects the value of its currency. This is particularly apparent during elections (a commonplace in most countries), where traders may view this event as an isolated instance of political instability and uncertainty, resulting in greater volatility in the forex market as a result. This is largely due to the possible change in governmental power, meaning there may be a potential shift in a country’s monetary policy and social ideology.

On the other hand, in instances where prospective party leaders are seen to be more financially responsible, or where their manifesto appears to advocate financial growth, elections can be viewed as a positive influence and therefore the country’s currency value can see an increase. A good example of this is the significance of Britain’s Brexit referendum result in 2016, where the country saw the value of the pound fall to a 31-year low due to financial market instability and the view that the outcome of the vote could negatively impact the country’s financial future.
 

exchange rates table in newspaper
Photo by Markus Spiske on Unsplash

 

How does public debt affect a country’s currency valuation?

Countries will sometimes borrow large sums of money in order to pay for public sector projects. While this activity typically stimulates the domestic economy as a result, countries seen to have large amounts of financial deficit are often less desirable to foreign investors.

In turn, large amounts of debt encourages inflation, meaning that if inflation rates are high, a country’s debt will be paid off using cheaper currency in the future. Another option is for a country’s government to decide to print more money and pay off their debts that way – however, this sudden increase in monetary supply will also cause inflation.
 

The impacts of natural disasters on currency

Not only are the obvious physical and economic impacts of a natural disaster detrimental to a country, but natural disasters can have a severely catastrophic impact on the country’s currency valuation. This is due to the impact a disaster can have on major factories and distribution centres, to name just a few. This, coupled with the natural uncertainty of socio-economic conditions as a result of a natural disaster, means that a country’s currency valuation is almost always inevitably likely to fall.

In addition to this, once a country has been hit by a natural disaster, damage to basic infrastructure such as housing and working facilities can crucially limit the economic output through trade from a region. As such, both private and governmental spending is directed into rehabilitating citizens, cleaning up and rebuilding infrastructure instead of being invested into other potentially advantageous economic ventures.
 

Photo by Burak K from Pexels

 

What do external factors mean for my forex strategy?

While, of course, it’s difficult to prepare for the unexpected in the forex market, a well-informed and strategic foreign exchange trader will appropriately utilise global events and general knowledge as a primary indicator within their currency trading strategy.
 

Therefore, in order to protect yourself against potentially volatile forex market fluctuations, it’s paramount that you continue to monitor political and economic conditions both within your own country and in countries all over the world. You can do this by consulting a forex calendar to ensure you’re making effective decisions based on educated opinions, as opposed to simple hunches.

Unsurprisingly, the forex market is driven by economic factors that impact the strength of a country’s currency based on it’s currency exchange rate. Want to find out more about how to read the markets? Join us on one of our award-winning forex training courses, where we’ll teach you in more detail about the factors and indicators to watch out for – ensuring you’re never left behind in this competitive, fast-moving financial market.