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Why Do Exchange Rates Move?
Floating Exchange RatesIn a floating exchange-rate environment, the exchange-rate responds to many factors including the flow of imports and exports, the flow of capital, relative inflation rates, etc. Often, limits
are placed on exchange-rate fluctuations according to government policies.
One factor affecting the exchange-rate between the
Australian Dollar and other currencies is the merchandise trade balance. By definition, the merchandise trade balance is the net difference between the value of merchandise being exported and imported into a particular country. For example, consider the exchange-rate for AUD/USD. Australia imports products from the U.S. To pay for them, Australians need US Dollars; therefore, the Australian companies trade Australian dollars for US Dollars. On the other hand, because Americans desire Australian-made goods, they purchase Australian dollars to pay for Australian goods. The net effect is an increase in the supply of US Dollars and Australian dollars. The Australian demand for American goods and services contributes to the demand for US Dollars while American purchases of Australian goods and services contribute to the supply of Australian dollars. In this case, the net difference between Australian purchases of American goods and services, and American purchases of Australian goods and services, is the merchandise trade balance between the two countries.
The flow of funds between countries to pay for stocks and bonds purchases also contributes to the currency exchange-rate between currencies. In the near term, these capital flows are greatly influenced by yield differentials. All else being equal, the higher the yield on German securities compared to American securities, the more attractive German securities are relative to American securities. An increase in German yields would tend to raise the flow of U.S. dollars into German securities as well as decrease the outflow of Euros to American securities. Combined, this increased flow of funds into Germany would lower the value of the U.S. dollar
and increase the value of the Euro, therefore, the Euro to U.S. dollar ("EUR/USD") ratio, as it is represented in the forex market, would decrease.
The rate of inflation is another factor influencing currency exchange-rates. Consumers try to avoid the eroding effect inflation has on their purchasing power. Consequently, goods from countries with a low inflation rate become more attractive than the goods from countries with higher inflation. In turn, the currency from the lower inflation country rises in value, while the currency from the higher inflation country falls in value. Both the inflation factor and the purchasing power of the currencies directly impact currency exchange-rates. For example, if the United States is experiencing lower inflation than its trading partner Germany, the DM/USD ratio rises to reflect the growing price level in Germany relative to the United States. This fact is rooted in the concept of a purchasing power parity, which holds that, over the long run, a currency exchange-rate adjusts to reflect the difference in price levels between countries.Exchange Rate Movement Creates RiskWhile all these examples illustrate how currency exchange-rates can float in the foreign exchange market, free-floating currency exchange-rates create risk. For example, when an American wine merchant contracts to buy 1,000 cases of French wine, the merchant may agree to pay in French francs, say 600 francs per case, when the vintage is ready for shipment in two years. However, over the next two years, the value of the U.S. dollar could drop from20 cents/franc to 40 cents/franc, raising the price of each case from $120 U.S. dollars to$240 U.S. dollars. Thus, pricing the wine in francs exposes the American wine merchant to a currency exchange-rate risk. Of course, if the wine was priced in dollars ($120 per case) it would relieve the American merchant from the currency exchange-rate risk. But now the French wine producer would suffer, as the value of the dollar fell from 20 cents/franc to 40 cents/franc. In this example the French merchant would only receive half as much per case (i.e., 300 francs).
Because of these risks, governments throughout history have intervened to fix currency exchange-rates. In 1944, for example, western world leaders met in Bretton Woods, New Hampshire, to create the International Monetary Fund to cope with world economic and financial problems that occurred following the Great Depression and World War II. As part of the agreement, the value of the U.S. dollar, the worlds leading currency at the time, was set at 1/35 of an ounce of gold. And, world central banks were asked to keep the exchange-rates of their currencies pegged to the dollar's gold content, with variations limited to plus or minus 1%. Since 1944, there have been several instances when world leaders have met to adjust the fixed currency exchange-rate; but these rates have been abandoned over the years, and volatility in the market continues. Firms exposed to currency-exchange risk have turned to the forex market and currency futures markets to manage these risks. In the forex market, transactions are customized where the rate of exchange and other terms are agreed upon by both parties. Participation in the forex market is generally limited to very large customers.Fundamental Versus Technical AnalysisWhile technical analysis concentrates on the study of market action, fundamental analysis focuses on the economic forces which cause prices to move higher, or lower, or stay the same. The fundamental approach examines all of the relevant factors affecting the exchange-rate between two currencies to determine the intrinsic value of each currency. The intrinsic value is what the fundamentals indicate one currency is actually worth against another currency. If this intrinsic value is under the current market price, then the currency is overpriced and should be sold. If market price is below the intrinsic value, then the market is undervalued and should be bought. Both of these approaches to market forecasting attempt to solve the same problem, that is, to determine the direction prices are likely to move. They just approach the problem from different directions.
A "fundamentalist" studies the cause of market movement, while a technician studies the effect. Most market traders classify themselves as either technicians or fundamentalists. In reality, there is a lot of overlap. Most fundamentalists have a working knowledge of the basic tenets of chart analysis. At the same time, most technicians have at least a passing awareness of the fundamentals. The problem is that the charts and fundamentals are often in conflict with each other. Usually at the beginning of important market moves, the fundamentals do not explain or support what the market seems to be doing. It is at these critical times in the trend that these two approaches seem to differ the most. Usually they come back into sync at some point, but often too late for the trader to act. One explanation for these seeming discrepancies is that market price tends to lead the known fundamentals. Stated another way, market price acts as a leading indicator of the fundamentals or the conventional wisdom of the moment. While the known fundamentals have already been discounted and are already "in the market," prices are now reacting to the unknown fundamentals. Some of the most dramatic market movements in history have begun with little or no perceived change in the fundamentals. By the time those changes became known, the new trend was well underway.
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