How Forex Market Affects Daily Currency Conversion
A currency exchange rate is the cost of exchanging one currency for another. Exchange rates are constantly fluctuating on Forex throughout the week as currencies are actively traded. It pushes the price up and down, as it does with other assets like stocks or gold.
The market price of a currency is different from the rate you will receive from your bank or exchange office. When you go to the bank to exchange currencies, you won't get the market price traders are getting. The bank will mark up the price to make a profit, as will providers of credit cards and payment services such as PayPal, when a currency conversion takes place.
Let's see how currency exchange rates work and the role of commodities and forex markets in daily currency conversions.
What Impacts Currency Exchange Rates?
Most exchange rates are determined by on-going trading activity in the world's currency markets. Factors that influence the exchange rates are numerous, and they mutually impact each other.
Short term moves on the exchange market are usually geared by demand and supply factors, rumors, and speculations. In case of high demand for a specific currency, its value will rise and vice versa. A currency that is too high or maybe too low can negatively affect the overall state's economy. That is where the government intervenes to protect the national economy, investments, and trade.
In international trade, the price in one country should be equal to the price of another. It's called the law of one price. Which frequently will not hold in the real world. To be fully implemented, the purchasing power parity is required. Since reality doesn't follow the economic theory, this law is rarely implemented. Still, interest rates, as well as relative prices, influence the exchange rates.
Fixed vs. Pegged rates
We can also make a difference between floating and fixed or pegged rates. Floating currency exchange rates are regulated by the market forces of supply and demand. Pegged rates imply that the national currency's exchange rate is set accordingly to one specific currency, most commonly USD, EUR, AUD. In this way, the danger of fluctuations and instability is limited. Also, in this way, the national government promotes the investment of specific countries.
Currency Speculations on the Forex Market
The forex market can be easily explained as an exchange office operating around the clock, where everyone can invest and profit from currency conversion, fluctuation in currency rates, options trading, or simply exchange. The forex market is ruled by the asset managers and hedge funds whose portfolios amount to billions of dollars. Financial institutions and governments often turn to the forex market to buy or sell currency to hedge against market volatility and movements.
The Role of Forex and Commodities in Setting Exchange Rates
The value of the main currencies is linked tightly to one country's commodity prices if the country's economy relies on the primary domestic industry. There is no definite rule regulating what commodity is linked to the specific currency, but there are currencies that showcase examples of the correlation between forex markets and commodities.
Let's take an example of the Canadian dollar. Canadian primary commodity is oil, so the Canadian dollar is correlated with oil prices. With the rise of oil prices, the price of the Canadian dollar goes up versus other currencies. Canada is the net oil exporter and tends to profit as much as possible from its exports when oil prices are high, which boosts the value of the CAD in the foreign exchange market.
As one of the most prominent currencies on Forex, the Australian dollar also depends on commodity markets since the Australian economy relies heavily on the mining sector, notably nickel, iron, gold, and coal exploitation and export. Australia is one of the biggest miners and exporters of gold. Therefore its price tends to change according to the price in gold bullions. Along with the increasing price of gold, the Australian dollar is going up compared to other major currency prices.
The Influence of Central Banks On the Currency Exchange Market
Financial institutions, governments, central banks, or even certain private organizations regularly publish reports which sometimes have significant impacts on the evolution of financial market prices. These reports comprise employment and unemployment, manufacturing production, household consumption, or economic growth.
As the pilot of monetary policies, the central banks significantly influence the foreign exchange market. While currency exchange rates are at the heart of global economic and financial balances, any change in monetary policy in a country results in a change in these balances. The influence of central banks on the Forex can be direct, like in the announcement of monetary policy decisions. For anyone aiming to trade on Forex, but also for anyone seeking to understand changes in exchange rates, it is important to know how central banks work and, in particular, the four main ones which are:
- The United States Federal Reserve (Fed)
- The European Central Bank (ECB)
- The Bank of England (BoE)
- The Bank of Japan (BoJ)
Generally, the rates published by national banks are indicative and are calculated based on the rates from many institutions and financial markets. When trading on Forex, it's not recommended to use them as a benchmark rate. When searching for the best exchange rates, you can consult many alternative sources that are publicly available. These sources could be many trading platforms and data vendors that may provide you with the exchange rates that aren't published by financial or government institutions.