What Drives Market Prices ?

In a floating exchange rate environment, the exchange rate is affected by many factors which include the flow of imports and exports, capital flows and relative inflation rates. Limits are often placed on exchange rate fluctuations according to government policies.

International Trade Flows

One factor that affects the exchange rate between the British Pound and other currencies is the merchandise trade balance. The merchandise trade balance is defined as the net difference between the value of merchandise being exported and merchandise imported into a particular country.

For example, consider the GBP/USD exchange rate. When UK companies import products from the United States, they need U.S. dollars to pay for them. Therefore, UK companies trade their British Pounds for U.S. dollars.

On the other hand, when U.S. companies import goods made in the UK, they need to buy British Pounds to pay for these goods. The net effect is an increase in the supply of British Pounds and U.S. dollars.

The UK’s demand for American goods and services increases the demand for U.S. dollars, while American purchases of British goods and services contributes to the increase in demand for British Pounds. The difference between the value of American purchases of British goods and services and the British purchases of American goods and services is the merchandise trade balance between the two countries.

International Investment Capital Flows

The flow of capital between the two countries for the payment of stocks and bonds purchases also contributes to differences in the exchange rate between their respective currencies. In the short term, capital flows are strongly influenced by yield differentials.

All else being equal, the higher the yield on British interest bearing securities compared to equivalent American securities, the more attractive British securities will be relative to American securities. An increase in yields on UK bonds would tend to increase U.S. dollar flows into British securities and decrease the outflow of Pounds into American securities.

Combined, the increase of capital flows into the UK would decrease the value of the U.S. dollar and increase the value of the Pound Sterling. As a result, the Sterling versus the U.S. dollar or GBP/USD exchange rate ratio, as represented in the forex market, would increase. Hence more U.S. dollars would be required to buy one Pound.

Inflation Rates

Inflation rates also affect foreign exchange rates. Inflation is the reduction in purchasing power of a currency that occurs when a country’s money supply grows faster than its real Gross Domestic Product or GDP.

This situation results in more money chasing fewer goods, which then boosts the prices of those goods. Because exchange rates express one unit of the base currency in terms of the counter currency, differences in the inflation rate between two currencies shifts their relative value.

As an example, if the United States experiences a rate of inflation higher than Britain, this will put upward pressure on the GBP/USD exchange rate. This influence reflects the falling value of U.S. Dollars relative to Pounds Sterling over time, as one Pound can purchase more U.S. Dollars because there are more U.S. Dollars around compared with Pounds.

The relative pricing of items in two countries can also affect their currencies’ exchange rate due to the concept of Purchasing Power Parity or PPP, where a particular good or basket of goods should theoretically have the same price in either country. Over a long term time horizon, the exchange rate should adjust to reflect the prevailing price levels in each country and move closer toward its PPP value.

Exchange Rate Movement Creates Risk

Historically, foreign exchange rate regimes have gone through times of fixed, floating and managed floating exchange rates. Each of these regimes had various central bank policies with respect to intervening in the currency market to maintain the official system.

The United Kingdom followed a policy of fixed exchange rates from 1944 to 1972 under the Bretton Woods System. The UK also participated in Europe’s Exchange Rate Mechanism or ERM until being forced by speculative pressure to devalue the Pound Sterling in 1992 rather than defend its currency by raising interest rates.

The Bretton Woods System of Fixed Exchange Rates

In 1944, western world leaders met in Bretton Woods, New Hampshire, to start the International Monetary Fund and found the World Bank in an attempt to cope with severe economic and financial problems following the Great Depression and World War II.

In the resulting Bretton Woods agreement, the value of the U.S. dollar, the dominant currency at the time, was fixed and convertible into gold at a rate of $35 per ounce. Central banks around the world were obliged to keep the exchange rates of their currencies pegged to the U.S. dollar and its gold content, with variations limited to plus or minus 1% around a central parity value.

The Bretton Woods system later collapsed when the United States unilaterally suspended convertibility of the U.S. Dollar into gold following sustained trade deficits that led to enormous reductions in its gold reserves.

However, some countries continued to have policies where their currencies were pegged to or managed relative to the U.S. dollar, with China having been one of the most prominent examples.

The U.S. Dollar’s Central Role in the Forex Market

The U.S. Dollar has retained most of its reserve currency status and is widely held by central banks. In addition, transactions in major commodities, such as gold and oil, are traditionally settled in U.S. Dollars. Due to these factors, U.S. Dollars are involved in most foreign exchange transactions, either on a direct or indirect basis.

Direct quotes for cross rates are typically only made for major cross currency pairs like EUR/GBP, GBP/AUD, EUR/JPY and EUR/CHF. Accordingly, to exchange a minor currency like the Indian Rupee for another minor currency like the Thai Baht, you would have to trade each component currency versus the U.S. Dollar, which acts like an intermediary currency.

The floating exchange rate regime currently prevailing around the world causes volatility and creates risk and uncertainty for forex market participants.

For example, when a British wine dealer enters an order to buy 1,000 cases of French wine, the merchant could agree to pay in Euros, for example, 100 Euros per case, when the wine is ready for shipment in two years time.

However, over the next two years, the value of the Euro could increase relative to Sterling from 0.68 EUR/GBP to 1.0 EUR/GBP, which would in turn raise the price of each case from 68 British Pounds to 100 British Pounds. Thus, pricing the wine in Euros gives the British wine merchant exposure to currency exchange rate risk.

Basically, if the wine was priced in British Pounds at £68 per case, then this would relieve the British merchant from currency exchange rate risk. Nevertheless, the French wine producer would feel the consequences, as the value of the British Pound dropped from 0.68 EUR/GBP to 1.0 EUR/GBP. In this example, the French wine merchant would take the loss that was previously experienced by the British wine importer.

Fundamental versus Technical Analysis

Fundamental analysis generally focuses on those economic forces that cause exchange rate movements, while technical analysis concentrates on the exchange rate movements themselves.

Both of these market forecasting approaches help people determine which direction exchange rates are most likely to move. They just approach the problem from a different perspective.

Why Fundamental and Technical Analysis are used

Using the fundamental approach involves examining relevant factors that affect exchange rates to assess a currency’s relative value when expressed in terms of another currency.  The fundamental relative value indicates what amount of another currency one unit of a particular currency is worth.

If this relative value rises above the current market exchange rate, then the currency becomes undervalued and buying pressure should emerge. Conversely, if the market exchange rate rises above the relative value, then the currency becomes overvalued and selling pressure would be expected.

What Fundamental and Technical Analysts Do

A fundamental analyst attempts to determine the causes of market movements, while a technician typically studies the effect on the market-determined exchange rate itself, which often involves finding patterns of market movement on charts or reading computed technical indicators.

Although most currency traders consider themselves either technical or fundamental analysts, considerable overlap typically occurs between the two primary disciplines of market analysis. Most fundamentalists have a working knowledge of technical chart analysis, while most technicians develop a basic awareness of fundamentals.

Conflicting Analysis

Despite the fact there is typically an overlap between the two disciplines, both are often in conflict with each other. For example, when

there is an important movement in the market, fundamentals often fail to explain or support the market’s new direction.

One explanation for such discrepancies is that the market price acts as a leading indicator of the known fundamentals, which are generally based on current conventional wisdom. The approaches usually realign at some point, although it may then be too late for the market analyst to act.

Basically, the known fundamentals are already discounted or priced into the market, so exchange rates instead react to unknown fundamentals. Some of the most dramatic historical market moves have started with hardly any perceived shift in the fundamental picture. The new trend was already well established when the fundamental changes driving it eventually became commonly accepted as fact.

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