Many of us may only think about exchange rates only when we go on holiday overseas and need to buy some travel money. However, for businesses that import and export or businesses with operations abroad, daily exchange rate fluctuations can have massive impact on their bottom line.

A higher exchange rate (or a stronger currency) makes a country’s exports more expensive, but imports cheaper, whereas, a lower exchange rate (or a weaker currency) makes the exports cheaper and imports more expensive.

A strong currency makes the country’s exports more unattractive to foreign markets, whilst making it more appealing for the country to import goods from overseas, thus, lowering the country’s balance of trade. A weaker currency raises the balance of trade, allowing the country to have more money coming in through exports than going out through imports. This in turn can influence the economy, especially if a country heavily relies on the profits from its exports – like, for example, China does currently.

“A low balance of trade is potentially hazardous to an economy, because if the country is spending more on exports than it is earning through imports, there will be a time when the money runs dry,” explains Jeremy Cook, chief economist at the foreign exchange company, World First.

“Ultimately, an exchange rate is the price of money. So just like with a pint of milk, the exchange rates are determined by market forces – the supply and demand on the foreign exchange markets. So if you’re in business of whatever shape or size, it is important to understand what influences exchange rates and affects the value of the world’s currencies.”

Here’s our run-down of some of the key factors.

Interest rates

An interest rate is the price of money on the domestic market. So this determines how much it costs for foreign investors to buy assets in the country in question. This means when interests either go up, or are expected to go up, the currency tends to strengthen as foreign investors begin to invest.Similarly, when interest rates are expected to be cut, the value of the currency tends to drop as well due to investors selling their assets.

Imports and exports

Just like anything else, the price of a currency goes up if the demand for the currency goes up. So if your national exports are high in demand, they will be also be buying your money to make the purchase, pushing up the demand. This makes the price of your currency go up, in other words the exchange rate goes up.

Health of the economy

Just like when buying shares in a company, people tend to invest in countries that are either doing well or continuing to do well. Whether or not the country is wealthy, if the country is expected to continue to grow, and grow fast, foreign investors will bring some money into the country and keep it there, so that their investment grows with the country. This will add to currency strengthening, because it increases the demand for the currency.

Everything else

Exchange rates are very vulnerable. Things like natural disasters, terrorist attacks, wars, riots and elections can have massive impact on exchange rates. This is because of market speculators whose ‘job’ is to make money from selling and buying currencies at the opportune moments. If you buy the correct currency at the correct time, you can make a huge profit. Each speculator has different view on what makes the exchange rate move.

For example, some speculators may have believed that an Obama win in the US Presidential election will have a good influence on the US economy, so they may have been encouraged to buy more US dollars.On the other hand, some speculators may have believed that a Romney victory would have been better for the US, so sold US dollars instead. If more people bought dollars after the election, then the dollar would strengthen, while if more people sold it, the dollar would weaken.

It is impossible to predict how exchange rates fluctuate and experts can only guess through close analysis. If you’re worried about exchange rates, you should get daily updates from various experts. But because no expert has a crystal ball, you should always take all market analysis as one opinion, and not a 100% accurate forecast.

 

To keep up to date with the latest exchange rates, check out the World First’s exchange rate updates.