Why exchange rates matter
An exchange rate is the rate at which one currency will be exchanged for another. That’s why it can be an important way of measuring a country’s economic health, or for assessing the suitability of an economy for business expansion.
But why do exchange rates fluctuate and what causes this volatility in exchange rates?
Let’s dive in a little deeper.
Volatility: Exchange rate volatility refers to the tendency for foreign currency to appreciate or depreciate in value and ultimately affects the profitability of a trade (or transfer) overseas.
1. Economic indicators: Inflation and government debt
Inflation rates impact a country’s currency value. A low inflation rate typically leads to a rising currency value, as its purchasing power increases relative to other currencies. Conversely, countries with higher inflation often see depreciation in their currency’s value compared to their trading partners.
Another economic indicator is government debt, which also plays a part in inflation rates. A country with government debt is less likely to acquire foreign capital, leading to inflation and likely to a depreciation in that currency.
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2. Interest rates
Interest rates are set by central banks as a way to curb rising inflation and steady a single economy or group of economies.
Exchange rates, interest rates, and inflation rates are all interconnected. We can see this through increasing interest rates which can cause a country’s currency to appreciate as the higher interest rates attract foreign capital.
This can contribute to a rise in the value of a currency and therefore the exchange rate. Cutting interest rates, on the other hand, can lead to a depreciation of the currency.
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3. Monetary policy and economic performance
If a country has a history of strong economic performance and sound monetary policy, investors are more likely to buy or invest in that country’s currency. This increases the demand and value of that currency.
Large-scale global economic events, like slowdowns in large economies, can simultaneously affect currencies around the world. This is known as a recession. A recession may also cause a depreciation in the exchange rate because interest rates usually dip during this time, but this isn’t always the case.
Countries with long-standing strong economic performance and monetary policy, like the United States are often regarded as “safe haven” currencies during times of global economic uncertainty. Safe haven currencies are often sought out in times like these, increasing their value and raising inflation.
This leads to the discussion of market sentiment and risk appetite.
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4. Market sentiment: investor confidence and risk appetite
Market sentiment, or investor confidence, plays a significant role in exchange rate fluctuations.
If investors perceive a country’s economy as stable and promising, they will be more likely to invest in that country’s currency, driving up its value.
Conversely, negative market sentiment can lead to a currency’s depreciation.
5. Geopolitical stability
The political state of a country can also affect the currency’s strength. This is called ‘geopolitical risk’.
Geopolitical risk is the risk posed to foreign investors by unexpected political developments in a region.
Naturally, if a country’s economy and political landscape remain predictable, investors are more likely to buy that currency. This causes an appreciation in the value of the country’s domestic currency from foreign capital.
The opposite effect is also true, unexpected events can lead investors to seek safe haven currencies for their money, often causing the currency in the affected country to depreciate.
6. Trade balance: Import and export value
A country’s Balance of Trade (BoT) is the difference in the value of exports and imports of goods. If the price of a country’s exports is greater than its imports, that means its ‘terms of trade’ have improved.
This can create a greater demand for that country’s exports, and in turn, a greater demand for the currency. Conversely, if a country is in a trade deficit, where they import more than they export, it can weaken a currency.
How can you make volatility work for you?
While exchange rate volatility is inevitable, there are strategies you can employ to mitigate its impact on your foreign exchange:
- Plan your transactions carefully:
If you anticipate making a large international payment, monitor exchange rates or work with a skilled OFXpert to understand the forex markets and consider timing your transaction when the rate is beneficial.
- Consider hedging tools:
Hedging tools, like Forward Contracts, can help you lock in an exchange rate for a future transaction, possibly protecting yourself from adverse fluctuations.
- Choose a reliable currency exchange provider:
Work with a reputable currency exchange provider like OFX, that offers competitive rates, low fees, and transparent transfers.
Remember, volatility is not always a bad thing. With the right help and tools, you can develop a risk management strategy that considers situations when volatility could work to your advantage.
Try our free forex risk management tools
OFX has risk management tools to help you navigate volatility
Using the right transfer type for your needs is the first step.
For example, a Forward Contract allows you to fix an exchange rate that suits your needs and then transfer the funds at a later date, up to 12 months in the future.
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Top 3 transfer types to manage your global money transfer needs
Spot Transfers
- Spot Transfers are completed quickly and securely, so you can make timely payments.
- No waiting around. You know your rate at the time the deal is done.
- Keep it simple. No need to track the currency markets or set alerts.
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Limit Orders
- Target an exchange rate that suits your needs.
- Limit Orders are convenient. You can target a rate for up to 6 months.
- Limit Orders can be used with other tools to help protect against currency risk.
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Forward Contract
- Lock in an advantageous rate for up to 12 months.
- Forward Contracts are a simple way to manage future currency risk.
- Lock in rates between 19 currencies, including all major currencies.
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Choose OFX as your trusted provider
OFX offers a range of tools and resources to help you stay informed about exchange rate movements and market news.
Stay knowledgeable about what is causing exchange rate fluctuations with OFXpert blog content. Explore additional factors that influence exchange rates like politics, economic policies, data releases, and current events more in-depth in our blog series.
As a highly regulated company with over 25 years of experience, an easy-to-use platform, and 24/7 dedicated OFXpert support, we are ready to provide a fast and secure currency exchange experience.
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IMPORTANT: The contents of this blog do not constitute financial advice and are provided for general information purposes only without taking into account the investment objectives, financial situation and particular needs of any particular person. OzForex Limited (trading as OFX) and its affiliated entities make no recommendation as to the merits of any financial strategy or product referred to in the blog. OFX makes no warranty, express or implied, concerning the suitability, completeness, quality or exactness of the information and models provided in this blog.
