Foreign Exchange refers to the buying or selling of one currency for another. Commonly referred to as Forex or FX, it is the most heavily traded market in the world. This is because countries, businesses, and individuals, all participate in it.
The equivalent of $4.5 billion US Dollars is traded every day. In the Forex market, currencies always trade in pairs – every transaction exchanges one currency for another.
So, if the USD/CAD exchange rate is 1.30, it costs you 1.30 Canadian Dollars to buy 1 US Dollar.
While sometimes confusing, it’s important to have an understanding of FX rates and how they work. If you don’t, it’s easier for banks and other financial institutions to charge you unnecessarily high exchange rates. But don’t worry, we’re here to help you out. Here’s everything you need to know about Foreign Exchange.
What Determines Foreign Exchange Rates?
Foreign Exchange rate provides a window to a country’s economic stability. Rates fluctuate daily and are heavily influenced by the following factors:
Inflation: Inflation is the general increase in prices with the fall in the purchasing value of money. A country with a lower inflation rate than another’s will see an appreciation in the value of its currency. A country withhigher inflation typically sees depreciation in its currency.
Balance of Payments: This is the difference in total value between payments into and out of a country. Payments received for exports of goods and services versus payments made for imports, determines the net balance of payments. If a country has a foreign exchange deficit due to spending more currency on imports, it causes depreciation of its currency as it tends to need more foreign currency than it has earned.
Terms of Trade: This relates to the balance of payments. Terms of trade is the ratio of export prices to import prices. A country’s terms of trade improves if its exports prices rise at a greater rate than its imports prices. This results in higher revenue, and a higher demand for the country’s currency, thus increasing the currency’s value.
Government Debt: Government debt is national debt owned by a country’s central government. Countries with high government debt are less likely to attract foreign capital, thus inflation and currency depreciation occur more frequently in such countries.
Interest Rates: Foreign exchange rates, interest rates and inflation are all related. Increasing interest rates cause a country’s currency to appreciate – higher interest rates provide higher rates to lenders. This attracts more foreign capital and causes an appreciation in the country’s currency compared to the country from where the foreign capital comes in..
Political Stability: A country’s political climate can have a huge affect on its currency. A country that has no political turmoil is more attractive to overseas investors. The more investors a country attracts, the more its foreign capital increases. This leads to an appreciation in the value of the country’s currency. If a country is facing a time of political uncertainty, its currency value tends to drop or depreciate. Eg: The British Pound’s value dropped significantly after the UK made the shock decision to leave the EU.
Recession: If a country is in recession, its currency weakens in comparison to countries that aren’t.
Recession causes interest rates to fall, and decreases a country’s chance to acquire foreign capital. As a result, the currency falters and its exchange rate weakens. While this goes contrary to currency changes due to rising interest rates, extremes on either side can lead to exchange rates weakening.
Speculation: When a country’s currency value is expected to rise, investors will demand more of it. Their plans to make a profit in the future will increase the demand for the currency. As a result, the currency’s value will rise – with this increase in value comes a rise in the exchange rate.
What Are The World’s Most Traded Currencies?
The world’s top 10 most traded currencies account for nearly 90% of Forex trades.
US Dollar (USD): The world’s most traded currency belongs to the United States of America. The US is the world’s largest economy, and is also the world’s primary ‘reserve currency’. It is held by central and commercial banks for the purposes of international transactions. Many commodities are priced in US dollars, including gold, oil, copper and most other metals.
Euro (EUR): The official currency of the European Union is the world’s second most traded. It is the world’s second biggest reserve currency. It is used by 19 of the 28 EU countries, this is known as the Eurozone.
Japanese Yen (JPY): Japan’s currency is by far the most traded currency in the Asian market. It is also the world’s third third biggest reserve currency. Oil is important in determining the Yen’s value. As a major importer, high prices can weigh heavily on Japan’s economy.
Pound Sterling (GBP): The British Pound is the official currency of the United Kingdom and its territories. In recent years, its value has been affected by the UK’s changing relationship with Europe. The UK has voted to leave the EU – Brexit is currently scheduled for 29 March 2019. The UK’s future trading relationship with the EU is likely to impact the pound in the future.
Australian Dollar (AUD): Australia’s currency is the world’s fifth most traded, and sixth biggest reserve currency. Australia is a major exporter of coal, iron and copper and other mined commodities. It is also a major importer of oil – shifts in the trading volumes and prices of these commodities impact AUD.
Canadian Dollar (CAD): Canada’s currency is the sixth most traded globally, the fifth largest reserve currency. Canada, like Australia, is also rich in natural resources and a major exporter of commodities. This means their prices can be a critical factor in determining CAD’s value. Canada’s major trading partner is the US- accounting for more than 75% of all exports and 50% of imports. Canada’s economy and the CAD’s value are sensitive to changes in the US economy and the US dollar’s value.
Swiss Franc (CHF): Switzerland has a reputation for financial services and banking secrecy.
This, coupled with the country’s sound monetary policies and low levels of debt, have made CHF a ‘safe-haven’ currency. It is also the eight most commonly held reserve currency.
Chinese Renminbi (CNY): Sometimes referred to as the ‘yuan’ – China’s currency is the seventh most held reserve currency globally. As China is a major exporter of manufactured goods, the Renminbi’s value depends heavily on the country’s terms of trade. China’s major trading partners are the United States and Europe. Trump’s trade war and its effects on US-China relations could have a big effect on CNY in the future.
Swedish Krona (SEK): Unlike the above currencies on this list, Sweden’s official currency is not a major reserve currency. Sweden’s major exports include cars, engines and telecoms equipment. This can result in demand for SEK falling in times of global economic downfall.
New Zealand Dollar (NZD): New Zealand’s official currency is also not a major reserve currency.
The strength of this currency largely depends on the balance of trade with key trading partners China and Australia. New Zealand’s main exports are agricultural produce (dairy and meat) – while its main imports are oil, and cars.
The rates you see on boards in banks/exchange bureaus are never that day’s true Forex market ones. They are always higher, because additional variable fees the bank is charging are included. Some online Money Service Businesses (MSBs) offer the live FX rate for conversions, like us here at REMITR.
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