The influence of exchange rate is vital for a trading economy. The exchange rates represent a cost to the firms and this is mainly because a commission is paid on the exchange of one currency for another. The changes in the exchange rate create a risk to the firms who hold assets in foreign currencies. The exchange rates affect the prices of exports that form a significant part of the aggregate demand and the price of imports. It is thus how the balance of payments gets affected.
It can be paradoxical! With weakening of domestic currency exports get boosted and imports become more expensive. In the case of exports, there is mainly an earning of foreign currency by moving goods outside the country. Exchange rate movements affect exports in two ways. One in terms of rate depreciation and the other in terms of rate variability (risk). Where, depreciation raises exports on the other hand, its associated exchange rate risk can offset the positive effects.
Depreciation lowers the foreign currency price or export exchange rates and this thereby increases the quantity of exports and the export revenue in domestic currency. Highly inelastic foreign import demand can actually lead to falling of the export revenue. There can be high ambiguity taking into precedence when export production incorporates high import content, since the domestic cost or price of exports rises with depreciation. At such times, exporters tend to price to market, lowering their domestic currency price to maintain export market share.
An exchange rate is a rate at which one currency is exchanged for another. It is the value of one country currency in relation to another currency. The exchange rates are determined in the foreign exchange market, which is open to a wide range of different types of buyers and sellers. The large global banks are involved in the interbank Forex markets through their external clients and own banks. External clients include other large banks, exporters, importers, multinational firms, central banks, and large non- bank financial institutions.
For example, EUR/USD: 1.1340 /1.1342. The first number quoted by the market maker is the market maker’s buy price for 1 unit of the base currency (1.1340). This is the bid quote, which is quoted to the exporter. The second quoted number is the market maker’s sell price for 1 unit of the base currency (1.1342). This is ask quote which is quoted to the importer.
The rate difference between ask price and bid price is called spread. The Bid is always the lower quote and ask is always the higher quote. Bid/ask spreads increases with exchange rate volatility and uncertainty. The Export Exchange Rate plays an important role for firms who export goods and import raw materials. When there is depreciation and exchange rates go down the exports will become cheaper and when the exchange rates go up the exports will become expensive.
For example, Exchange rate increases $1 = INR 70.86. Here, USD as appreciated and Rupee has become cheaper. Now, one can buy more goods from India than before for the same amount of dollars. As Indian goods and services have become relatively cheaper, the US imports increase and Indian export increases. In exchange rate terms, appreciation makes exports more expensive and reduces the competitiveness of exporting firms.
India exports over 7500 commodities and goods to more than 190 nations. Indian exports rose to USD 26.98 billion, 17.9 percent year-on-year in October 2018. This was mainly because India saw INR depreciating to its lowest levels during the month of October.
Therefore Business strategies of Export companies and movement entirely depend on the exchange rate of the country. It has a direct effect on global trading and production structure.
In general, when price elasticity of demand for exports and imports is low, there can be depreciation of exchange rate and this may lead to worsening of the trade balance.
Few Short Term Reasons that Influence & Affect Forex Market Trading
The forex market trading is not difficult and if one have a basic on when the foreign exchange of a country will change. The crux lies on how countries and their exporting as well as importing firms know that?
Over a period of time it has been realised that the forex market gets affected by certain macroeconomic factors and we therefore bring out in this piece some factors that can has a direct bearing over the forex market trading.
Political Landscape- The economy tends to grows when the government willingly takes steps to improve the living standard of its population. For such to happen, a stable government may be the first sign of an investor-friendly country. This also ensures that the economies have fewer roadblocks and higher chances to grow.
This factor is important to forex market trading as traders mostly opt to buy currency of a country whose political conditions are stable. In this area, the perfect instances of foreign exchange trading include news of Brexit which led to a dive in the value of the GBP when compared to the US Dollar.
Inflation Rate- Second factor which also has an influence on the exchange rate is the current inflation rate as it can also determine what would be say the export exchange rate today. There are no surprises there and if the country’s inflation rate is relatively lower in comparison to the other, its currency is expected to appreciate in value as compared to a currency with the higher inflation rate.
Thinking of it from the logical point of view, inflation rate is related to forex market trading as investors would seek to buy a currency where the inflation rates are lower. For instance, if the currency inflation rises in Zimbabwe, its currency value automatically gets devalued aggressively. So in this case, you will find Zimbabwean dollar is not an attractive destination for Forex traders.
Interest Rate- Again, interest rates are crucial to traders in the forex market as the higher the rate of return, the more interest is accrued on currency invested and this makes the profit margin higher. Further higher interest rates tend to attract more foreign investments and push up the demand for and the value of the home country’s currency. Contrarily, lower interest rates tend to be unattractive for foreign investment and decrease the currency’s relative value. This is usually made by any of the eight global Central Banks for their respective countries.
The interest rate charges are an indirect response to other economic indicators observed throughout the month and they can potentially move the market immediately and with greater zeal. As rate changes often they have the greatest impact on traders to help in understanding how to predict and react to such volatile moves that leads to higher profits.
Commodity Imports – As countries largely depend on commodity imports for domestic consumptions, its currency usually tend to fall. The increase in gold imports can result to trade deficit and this leads to depreciation in the currency. This can result in a sharp decline in the currency exchange rate.
Long term factors that influence the forex trading trends include factors such like-
Balance of Trade Impacts Currency Exchange Rates
The exchange rate for export as well as import is directly related to balance of trade and such influences currency exchange rates through its effect on the supply and demand for foreign exchange. Any nation’s terms of trade are a ratio that is comparing export prices to import prices. Say for example, if the price of a country’s exports rises by a greater rate than the imports (trade surplus), its terms of trade favourably gets stimulated and this tends to show currency appreciation. However, if the price of a country’s imports rises more than the rate of exports (trade deficit), their currency’s value will decrease in relation to trading partners.
Both political stability and economic performance foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. As already mentioned, political turmoil for instance can actually pose a degree of loss of confidence in a currency and a movement of the capital to the currencies of more stable countries. Thus, the grasp of the thing is that, the return of a portfolio can hold currency that’s affected by that currency’s exchange rate.
Most international businesses are used to handling multiple currencies. International businesses appear to be increasingly eliminating exchange rate risk by trading entirely in one currency and this usually the US dollar but at certain risk to global trade. There is a striking difference between US and the rest of the world. For instance in Japan, about 71% of imports is invoiced in USD even though it is just 13% which comes from the US. The imports in Japan include oil and commodities, which are priced in USD as they are sold on global markets. Even non-commodities are often traded in USD and this includes between countries like Japan and Indonesia.
Export exchange rate of USD matters for a country as it automatically raises export prices in local currency while it may simultaneously also raise import prices despite the fact that other exchange rate relationships may be moving in the contrary direction. So for all countries across the world, from an individual level, a rising USD should therefore depress imports and increase exports. At times when there is a global rise in prices due to strengthening of USD exchange rate, international business cuts export prices to offset the USD appreciation for their customers. Again, it may also be the contrary and international businesses may not be willing to cut export prices if their input costs are rising. In such a case, customers therefore reduce their orders or substitute it with cheaper goods. One country’s export is another country’s import and when everyone is reducing orders in response to a strengthening USD, their trade volumes fall for all countries including that of US.
Read more about Export and Import Finance
10 Dec 2019 05:19 PM
Most of us understand the importance of the global interest rate benchmark LIBOR – London Inter-Bank Offered Rate, especially when millions of dollars are benchmarked against it for decades since 1984.
29 Nov 2019 02:16 PM
Ideally a trade constitutes a foreign exchange transaction but currency can be traded without any underlying which makes it a risky proposition.
26 Nov 2019 12:29 PM
Foreign exchange risk is a financial risk which exists when a home currency is converted into another during the transaction.
14 Nov 2019 02:54 PM
A foreign exchange transaction is recorded in the books of accounts at an exchange rate though the payment is made at a different exchange rate. This leads to transactional foreign exchange loss or gain.
07 Nov 2019 10:48 AM
Modern foreign exchange market started its shift from a fixed exchange rate to a floating exchange rate system. Thus a global decentralized, over the counter (OTC) market for trading of currencies evolved which determines the forex rates.
29 Oct 2019 05:00 PM
Trading in the financial markets is what increases the volumes especially when some markets are open across the borders over different time zones. Each market has its underlying asset which is tradable over the exchange.