Foreign Exchange or Forex is a network of buyers and sellers who can transfer currency between each other at an agreed price. It is a way by which individuals, businesses and central banks can convert one currency into another — in case you have ever travelled abroad, then you have most likely made a forex transaction.
Although a lot of foreign exchange is done for practical purposes, the majority of currency conversion is undertaken with the aim of earning a profit. The amount of currency that is converted every day can make price movements of some currencies extremely volatile. This volatility is what makes forex so attractive to traders.
The forex market is made up of various currencies from all over the world that can make exchange rate predictions difficult because there are many factors that contribute to price movements.
However, similar to most financial markets, forex is primarily driven by the forces of demand and supply, and it is important to have an understanding of the influences that drive the price fluctuations.
The supply is controlled by central banks, which can announce measures that will have a significant influence on their currency’s price. Quantitative easing, for example, involves injecting more money into an economy and can result in the currency’s price drop.
Market sentiment, which is frequently in reaction to the news, can also play a major role in driving currency prices. In case the traders believe that a currency is headed in a certain direction, they will trade accordingly and might convince others to follow the same path, thereby increasing and decreasing the demand.
Investors and commercial banks tend to want to put the capital into economies that have a stronger outlook. Hence, if a positive piece of news hits the markets about a certain region, it will encourage investment and increase the demand for that region’s currency.
Only if there is a parallel increase in the supply of the currency, the disparity between demand and supply will cause its price to increase. In the same way, a piece of negative news can cause investment to decrease and lower the currency’s price. This is the reason why currency stands to reflect the reported economic health of the region they represent.
Investors will try to maximize the return they can get from a market, along with minimising their risk. Therefore, with interest rates and economic data, they might also look at credit ratings and decide where to invest.
The credit rating of a country is an independent assessment of the likelihood of repaying its debts. A country that has a high Friday treating is perceived as a safer area for investment than one with a low credit rating. This often comes into particular focus when credit ratings are upgraded and downgraded. A country that has an upgraded credit rating can observe its currency price rising and vice versa.
Economic data is a crucial part of the price movements of currencies for two reasons. Indication of how many economies are performing, and also offers insight into the central bank’s next steps.