In free market, it is the
demand and supply of the currency which should determine the exchange rates but
demand and supply is the dependent on many factors, which are ultimately the
cause of the exchange rate fluctuation, some times wild.
The volatility of exchange
rates cannot be traced to the single reason and consequently, it becomes difficult
to precisely define the factors that affect exchange rates. However, the more
important among them are as follows:
·
Strength
Of Economy
Economic factors affecting
exchange rates include hedging activities, interest rates, inflationary
pressures, trade imbalance, and euro market activities. Irving fisher, an American economist,
developed a theory relating exchange rates to interest rates. This proposition,
known as the fisher effect, states that interest rate differentials tend to
reflect exchange rate expectation.
On the other hand, the
purchasing- power parity theory relates exchange rates to inflationary
pressures. In its absolute version, this theory states that the equilibrium
exchange rate equals the ratio of domestic to foreign prices. The relative
version of the theory relates changes in the exchange rate to changes in price
ratios.
·
Political
Factor
The political factor
influencing exchange rates include the established monetary policy along with
government action on items such as the money supply, inflation, taxes, and
deficit financing. Active government intervention or manipulation, such as
central bank activity in the foreign currency market, also have an impact.
Other political factors influencing exchange rates include the political stability
of a country and its relative economic exposure (the perceived need for certain
levels and types of imports). Finally, there is also the influence of the
international monetary fund.
·
Expactation
Of The Foreign Exchange Market
Psychological factors also
influence exchange rates. These factors include market anticipation,
speculative pressures, and future expectations.
A few financial experts are of
the opinion that in today’s environment, the only ‘trustworthy’ method of
predicting exchange rates by gut feel. Bob Eveling, vice president of
financial markets at SG, is corporate finance’s top foreign exchange forecaster
for 1999. eveling’s gut feeling has, defined convention, and his method proved
uncannily accurate in foreign exchange forecasting in 1998.SG ended the
corporate finance forecasting year with a 2.66% error overall, the most
accurate among 19 banks. The secret to eveling’s intuition on any currency is
keeping abreast of world events. Any event,from a declaration of war to a
fainting political leader, can take its toll on a currency’s value. Today,
instead of formal modals, most forecasters rely on an amalgam that is part
economic fundamentals, part model and part judgment.
o
Fiscal
policy
o
Interest
rates
o
Monetary
policy
o
Balance
of payment
o
Exchange
control
o
Central
bank intervention
o
Speculation
o
Technical
factors
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