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Currency, by definition, is a medium of exchange for goods and services in a market. It refers to the system of money that a country uses and accepts. Most countries worldwide have a unique currency that their government issues and circulates. On the other hand, some countries share a currency. An example is the (€) Euro, which nineteen European countries share and use.
In most financial services, money is involved. And ever since the world has embraced technological advancements, financial investments and transactions have become prevalent. Today, you can manage and monitor currencies’ fluctuations and exchange rates worldwide. On top of that, you can also trade currency pairs in the forex market conveniently.
In forex, currencies are the most critical factor that keeps the market going. Without them, there will be nothing to trade, sell, and buy in forex. Indeed, currencies are the backbone of the forex market.
Trading currency pairs in forex
The ultimate concept of the forex market is to trade currency pairs to make a profit. Forex traders choose a currency pair they can likely sell and trade at a higher rate than when they bought it. The most popular currency pairs are called “major pairs,” which always pair with the U.S. dollar.
The position of currency pairs is standard, where the base currency always comes first and is divided by a slash from the quote currency. An example is this EUR/USD pair. In this example, the (€) Euro is the base currency, and the ($) U.S. Dollar is the quote currency. According to Investopedia, EUR/USD is the most liquid currency in the market, followed by USD/JPY. In other words, those pairs are the most profitable and can guarantee returns.
Market fluctuations in forex
Every financial market is volatile and varies on market conditions, liquidity, and investor demand. The forex market is known to be a highly volatile market because its assets are currencies. And since currency rates fluctuate daily, the market’s condition is not guaranteed.
Many professional traders suggest starting with major pairs in the forex market. Why? Because if a pair is liquid, its volatility is usually low. Even though volatility makes trading unpredictable, it keeps the forex market going. There will be no trading activity if there are no price fluctuations. That’s why when trading forex, it’s critical to have strategies and plans to help you take advantage of the market’s volatility. That includes understanding the factors affecting currency pairs’ volatility.
Every transaction we do affects the price movements of currency pairs. But there are specific factors that every trader must monitor and understand to help them make strategic decisions in trading. Let’s look at some factors that affect currency pairs’ volatility.
1 – Changes in inflation rates
Inflation, by definition, refers to the price increase in an economy. When inflation happens, it consequently decreases people’s purchasing power. Inflation occurs when the costs of production of consumer goods rise. That includes increased demand for raw materials, wages, and more.
When the demand for a product or service increases, inflation could happen. Inflation affects the volatility of currency pairs in the forex market because it involves changes in the market’s purchase behaviours. In simpler terms, high inflation rates affect the market negatively because they decrease currency value. On the other hand, a low inflation rate increases their value.
2 – Changes in interest rates
Inflation and interest rates are related, and they both affect the movement of exchange rates. The role of interest rates in an economy is coordinating money savers, borrowers, and investors. In simpler terms, we can view interest rates as the price of money.
In economics, countries try to balance inflation with interest rates to prevent an imbalance in economic growth and consumer demand. The easiest way to understand the concept of interest rates is through bank savings. Interest rates pertain to the rate of return on investments and savings. They affect the forex market because their movement affects the demand for a currency. Hence, interest rates impact exchange value.
3 – International trade between nations
Another factor that affects the volatility of currency pairs in the forex market is international trade between nations. The costs of imports and exports in a country affect its value, hence impacting the market. If a country’s exchange rate appreciates, the value of its currency in the market also increases.
Currency appreciation affects international trade because if the expenses of a country increase, the goods they export decrease. When that happens, they’ll prefer to import goods from another country because buying goods from other nations is cheaper. In other words, when the value of a currency increases, it also increases the demand for imports.
4 – Political news and changes in a country
The government of a country is its governing body and is responsible for making decisions about its monetary policies. Since the government can change economic policies in a country, those changes also affect the spending and regulations of its sectors and industries. If businesses in a country were to follow government spending regulations, it could change its supply and demand.
Election seasons in a country also impact forex traders’ perception and confidence in a currency. Professional traders take the time to monitor and learn the political parties in a country with propositions that would benefit its economic growth and performance.
5 – Economic performance of a country
When a country’s economic performance is good, it gives businesses, consumers, and investors confidence in the country. If a country’s economy improves and has proven stability, it influences business decisions and investments. On the other hand, if its economy has poor performance, investors are likely to withdraw and not pursue deals in the country.
Economic performance affects currency pairs because poor economies produce weak currency values. On the other hand, if a country’s economy is stable, its value tends to be stronger because a higher GDP (gross domestic product) could strengthen its significance in the forex market.
Every financial movement in a country affects its currency value in the forex market.
The five factors I discussed indicate that every financial movement in a country determines its currency value. Regardless of how small or big the financial transaction or changes in its regulation is, it could influence its value in the forex market. That’s why as a trader, you need to learn and understand the factors that could fluctuate the volatility of the currency pairs you’re trading in the market.
Photo by Nick Youngson from Pix 4 Free, free to use under Creative Commons license
