Q&A - What causes an exchange rate to change?
Friday, May 01, 2009
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An exchange rate is a price of a currency. The price is determined by the forces of demand and supply in the currency markets. Just like the commodity markets for wheat, oil and coffee, the price of a currency will reflect the amount of the currency that consumers and businesses want to buy (demand) and sell (supply).
Currencies are traded on in international currency markets 24 hours a day. Many billions of pounds and other currencies are traded every hour, to service the needs of governments, businesses and millions of individuals.
Here are some reasons why there is demand for a currency:
• Businesses need to pay for invoices from overseas suppliers (e.g. a US supplier sending goods to the UK and pricing the invoice in dollars)
• Businesses needing to convert payments they have received from customers in one currency into another (e.g. a customer in Italy pays a UK business in Euros – which it wants to convert into pounds before putting it in the bank)
• Consumers and business people buying currency before taking a trip or holiday overseas.
• Businesses sending back profits (cash) from their overseas operations to the base currency
Currency markets are also affected by speculative demand and supply. Currency traders bet on which way they think exchange rates will move. If they think that there will be excess demand for a currency and that it will strengthen, then they may buy that currency and then look to sell the currency when the exchange rate has risen (making a profit)
A currency is also affected by interest rates. For example if interest rates in the UK rise, then holders of other currencies may swap them into pounds in order to gain access to a higher interest rate.
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