Put simply, exchange rates compare the value of one currency to another. They measure how much of one currency it takes to purchase a unit of another.
Exchange rates are ultimately determined in global foreign exchange markets by the supply and demand of currencies. Economic factors like inflation, interest rates, and geopolitical events influence these market forces.
This article explains the key factors that influence exchange rates. These include floating rates, fixed rates, macroeconomic factors, commodities, and the foreign exchange market itself (also known as FX or the forex market).
How are exchange rates determined?
Why do so much? Understanding how exchange rates are determined and what drives their volatility can help you get the most out of your money when traveling abroad or sending money across borders.
Under the current global floating exchange range system (more on that soon), currency fluctuations result from the forces of supply and demand on a global scale.
In short: Exchange rates compare the value of two currencies as they change over time. Currency values fluctuate constantly because they’re traded 24/7, five days a week.
Setting floating vs. fixed exchange rates
Currency exchange rates are determined in two main ways:
- Government policy, called fixed exchange rates
- Market forces, known as floating exchange rates
In a fixed exchange rate system, the government or central bank proactively maintains currency values relative to a specific standard. Historically, fixed exchange rates were anchored to gold or silver, with currency units defined as a specific weight of metal.
A drawback of fixed rates is that governments and central banks often have to work against market forces to maintain a currency peg (the policy a country uses to set a fixed exchange rate). This might call for intervention via monetary policy tools such as reserve management, interest rate adjustments, and capital controls.
Nowadays, most of the world operates with floating exchange rates, where governments and central banks allow currency values to fluctuate freely in financial markets.
Some argue that today’s global economy incorporates elements of both free-floating and managed systems, with occasional government intervention to maintain currency values.
Factors that determine exchange rates
Understanding how and why currency fluctuates can be a big help when sending money internationally or converting currency before you travel.
Here are five factors that influence currency exchange rates:
Fixed exchange rates
Under fixed exchange rate systems, central banks actively shape monetary policy to peg their currency’s value within a narrow range.
This is intended to support their economic goals and maintain financial market confidence. Central banks have several monetary policy tools to do this. Here are three of the most important.
- Reserve management: Central banks maintain reserves of foreign currencies and can buy or sell them in the open market to influence demand and supply and stabilize exchange rates.
- Quantitative easing: Central banks buy government bonds and other securities to lower interest rates and increase the domestic money supply.
- Interest rate adjustments: By adjusting interest rates, central banks can attract or discourage the incoming flow of capital from outside the country, which impacts currency exchange rates.
Floating rates
Today, the world’s major currencies have where currency values fluctuate in currency markets. This includes the world’s most traded currencies: the United States dollar, the euro, the Indian rupee, and the Japanese yen.
In this system, the supply and demand of the currencies themselves largely set currency values. In other words, market forces drive exchange rates. These forces include:
- Economic performance indicators, such as national gross domestic product (GDP) growth and industrial output, impact currency valuations.
- Political stability and governance build investor trust. Perceived political risk also influences currency values.
- Prevailing interest ratesalso play a crucial role. For example, higher rates can attract foreign capital, leading to appreciation of the currency.
- Trade and current account balances shift the supply and demand dynamics of currencies, as international demand for a nation’s exports will create demand for their currency.
Other important influences on currency exchange rates include inflation rates, market sentiment, geopolitical events, fiscal policies, commodity prices, and cross-border capital flows.
The interbank foreign exchange market also plays a huge role in determining global currency valuations. The interbank market is where major banks and financial institutions balance currency demand and supply to set benchmark exchange rates. These benchmark rates then guide retail exchange rates for consumers and businesses around the world.
Macro factors
Macroeconomic fundamentals such as inflation, interest rates, and economic growth can have huge effects on currency exchange rates. Here’s how:
- Inflation: High inflation reduces a currency’s purchasing power, making exports more expensive, weakening demand, and leading to a drop in a currency’s value.
- Interest rates: Central banks use interest rates to stimulate or cool economic activity, which affects exchange rates. Higher national interest rates attract foreign capital and make a currency more attractive to hold. Conversely, lower rates tend to have the opposite effect.
- Economic growth: GDP measures the health of an economy, and GDP growth signals stability and investment opportunities. This is attractive to foreign investors and can increase demand for the nation’s currency, positively affecting its valuation.
Commodities
Commodities are products of agriculture or mining, such as oil, steel, wheat, or rare earth minerals. They also have a major role in determining currency exchange rates, as changes in commodity prices can significantly impact a country’s export earnings.
How it works: When demand rises for a country’s main exports, it often strengthens demand for its currency. This brings increased revenue from exports, leading to a trade surplus.
This cycle improves the country’s terms of trade, which is the ratio of export prices to import prices. As terms of trade improve, the country earns more from exports than it spends on imports. This boosts a nation’s economic health and, consequently, the value of its currency.
Forex
When you send money internationally via money transfer services like Western Union, you participate in the world’s largest, most liquid financial market.
Foreign exchange (forex) markets are active around the clock across time zones. Other participants include banks, investment funds, corporations, and retail traders.
The Bank for International Settlements (BIS) reported a record $7.5 trillion per day traded in forex in 2022, up from $6.6 trillion three years earlier.
Here are three key drivers, among many, that cause exchange rate changes in the forex markets:
- Trader and investorpositions: Speculation on currency values is a major driver of rate changes. Traders aim to profit from anticipated rate movements, and large speculative bets by institutions can become self-fulfilling as they drive significant market swings.
- Trading volumes: Dramatic changes in trading volumes of specific currencies suggest changing investor sentiment, affecting volatility and market depth.
- Market sentiment: Investor sentiment affects currency values. For example, during periods of economic uncertainty, the value of safe-hav
FAQs
What factors determine exchange rates?
The key factor in determining currency exchange rates is the supply and demand of currencies on global foreign exchange markets. In short, a currency’s price will rise if demand is high, and its price will fall if demand is low.
Beyond that, the dynamics of supply and demand are influenced by many political and economic forces. These forces include inflation rates, interest rates, economic growth, political stability, and geopolitical events.
How does the government determine the exchange rate?
Nowadays, the world’s major currencies have floating exchange rates. In this system, market forces determine currency values, limiting a government’s ability to determine exchange rates.
Governments occasionally intervene to meet economic objectives. To do this, governments and central banks use monetary policy tools such as interest rate adjustments, buying or selling currency in the open market, and capital controls.
How do banks decide exchange rates?
Commercial banks play a major role in determining global exchange rates. They do this on the global interbank forex market, where currency supply and demand set benchmark exchange rates.
Banks engage in a range of activities that help determine currency exchange rates. These activities include actively trading currencies, fulfilling orders, managing risk for clients, and more.
This article originally appeared on Westernunion.com and was syndicated by MediaFeed.org.
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8 Ways to Maximize Your Investments With Robo-Advisors
If you’re too busy to stay up-to-date on financial markets and investing strategies, one of the best ways to boost your returns with minimal effort is using a robo-investing platform. Whether your goal is to save for a new car soon, build a multimillion-dollar nest egg for retirement, or anything in between, I’ll review what a robo platform is and eight benefits of using one.
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Understanding eight primary benefits of robo-investing platforms can help you take the right amount of risk, cut fees, and meet your short- and long-term financial goals.
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You get SIPC protection.
Robo investing platforms offer features and technology you won’t find with traditional financial firms, and I’ll review many of them here. However, one benefit that’s the same is getting protection from the Securities Investor Protection Corporation (SIPC) for your robo accounts.
The SIPC protects customers of SIPC-member firms if the company fails and can’t repay their investments, like stocks, bonds, mutual funds, or cash. Therefore, if your robo platform goes out of business, the SIPC helps you recover up to $500,000, including up to $250,000 of lost cash.
However, the SIPC never covers losses due to market volatility or investment decline.
Also, note that it’s different from FDIC (Federal Deposit Insurance Corporation) insurance, which participating banks offer. So, don’t confuse the SIPC with FDIC insurance, which covers up to $250,000 of your deposits per banking institution per account ownership category, such as individual or joint accounts.
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Another reason robo-investing platforms are just as safe as many investing companies is that they’re regulated by the Securities and Exchange Commission (SEC) as registered fiduciaries. A fiduciary is required by law to act in their customers’ best interests.
Note that many online brokerages are not fiduciaries. They operate as a transaction-based stock broker and are not required to act in your best interest.
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Most robo-investing platforms offer various account types, such as high-yield savings, taxable brokerages, and tax-advantaged retirement accounts, like IRAs. I have all those accounts with Betterment, which has been my robo-advisor for decades. Another good platform to check out, especially for beginners, is Acorns.
For instance, my savings are for emergencies and planned short-term purchases. My brokerage is for medium-term goals, such as expenses I’ll have in more than about three years from now. And my IRAs are building wealth for the long term, so I have plenty of income in retirement.
Some robo platforms may also offer retirement plans for the self-employed, such as a solo 401(k) or SEP-IRA, which is the type I use. Or they may offer regular 401(k)s, which you could provide to employees if you run a small business.
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Robo-investing is an automated way to build wealth using a portfolio of funds. The platforms allow you to choose your level of risk based on an initial intake questionnaire to consider your age, savings, and goals. Then, they choose various index or exchange-traded funds (ETFs) with underlying assets that match your risk profile. But you can always increase or decrease your desired risk level as needed.
Robo platforms exist to prevent you from losing money by picking individual stocks, which can be more of a gamble than an investment for the average person. Investing in funds means buying hundreds or thousands of underlying securities, such as stocks, bonds, and real estate. In other words, you purchase the returns of the market instead of just one company, such as Google or Disney, which cuts risk.
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The optimized combinations of funds used by robo platforms represent different asset classes. They might include domestic or international equities, bonds, real estate, or an entire index, such as the S&P 500 or the Wilshire 5000. While swaths of the market can undoubtedly decline, owning funds over a long period, such as at least five years, reduces your risk.
For example, from 1973 to 2022, the US stock market returned an average of 11.7% annually. If you invested $10,000 in a total market index fund in 1973 and left it untouched, you’d have over $2.5 million today.
Assuming a more moderate average annual return of 7%, a $10,000 investment today will grow to about $76,000 if left alone for 30 years. But if you invest $10,000 annually, or about $833 a month, with a 7% return, you’ll have more than $1 million after 30 years.
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In addition to making you a diversified investor, robo platforms aim to cut your expenses. They charge fees that are much lower than many human financial advisors. That’s because they use technology, like algorithms, to deliver their service at a lower cost and offer low-cost index funds and ETFs.
For example, an advisor charges about 1% to 2% of a portfolio value they manage annually. If the market allows you to earn 7%, and an advisor takes 2% off the top, you only make 5%. And, you still pay an advisory fee even in years when the market underperforms. The larger your portfolio, the smaller the management fee should be, but it still adds up.
Robo platforms may charge less than 0.35% annually, which is a bargain. For instance, if you have $100,000, your fee could be $350 a year or about $29 monthly.
You also pay fees for the funds in your portfolio, known as an expense ratio. They automatically get deducted from your balance, so many people mistakenly believe they don’t pay investing fees. Remember that no-fee investing doesn’t exist–you should expect to pay reasonable costs, even with a small portfolio.
However, wise investors should do everything possible to minimize fees, especially during the accumulation phase of life, where you may not need specialized advice.
I’m not saying talented advisors shouldn’t be fairly compensated for their guidance and investment management services. But you’ll likely only need ongoing financial management if you have a large portfolio or are approaching or starting retirement.
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Robo platforms routinely monitor the asset classes you own and rebalance them back to your intended proportion and risk tolerance. They sell fast-growing fund shares and buy slower-growing ones to keep the original shape of your portfolio.
For example, if the stock market rises, your portfolio could become overweight with stocks, which are inherently riskier than most other asset classes. The solution is to sell shares of stock funds and purchase other asset classes, such as funds with bonds or cash, to ensure you’re not vulnerable to more investment risk than you want.
That makes robo-investing an excellent way to stick to a plan in mathematical detail. An algorithm won’t sell shares in a panic if prices go down or buy shares rising fast out of greed. It keeps you from trying to beat the market or doing something undisciplined with your money.
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Many robo platforms offer automated services to reduce your income taxes, known as tax-loss harvesting. It’s a strategy provided by most traditional investing companies, but it can be manual, time intensive, and therefore expensive compared to robo services.
Tax-loss harvesting is when you sell some investments as a capital loss to offset capital gains or other taxable income in your portfolio. It gives a typical investor who uses it a $3,000 deduction against their ordinary income tax.
For example, if you have a 20% average tax rate, a $3,000 deduction would save you $600 annually. That’s likely more than enough to cover the annual fees a typical robo platform charges!
Tax-loss harvesting legally lowers your net taxable income if certain conditions are met and you use a taxable brokerage account. It’s not a strategy for retirement accounts because your taxes on gains are either deferred or tax-free when you make withdrawals.
Because robo platforms are software-based, they can make complicated tax-loss harvesting calculations and required trades at scale and for a low cost to customers. Your responsibility is to file the paperwork the platform sends you–Form 1099-Bopens pdf file to report capital gains and losses and 1099-DIVopens pdf file to report dividends–-with your tax return.
This article originally appeared on Quickanddirtytips.com and was syndicated by MediaFeed.org.
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Bitcoin: Breaking Down the History (& Controversy)
https://www.msn.com/en-us/money/markets/bitcoin-breaking-down-the-history-controversy/ar-AA1o5Q2d
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