Factors that Affect Foreign Exchange Rates Foreign exchange rates are determined by supply and demand for currencies. Supply and demand, in turn, are influenced by factors in the economy, foreign trade, and the activities of international investors. Capital flows, given their size and mobility, are of great importance in determining exchange rates.

Factors that influence the level of interest rates also influence exchange rates among floating or market-determined currencies. Currencies are very sensitive to changes or anticipated changes in interest rates and to sovereign risk factors. Some of the key drivers that affect exchange rates include: • Interest rate differentials net of expected inflation

• Trading activity in other currencies

• International capital and trade flows

• International institutional investor sentiment

• Financial and political stability

• Monetary policy and the central bank

• Domestic debt levels (e.g., debt-to-GDP ratio)

• Economic fundamentals

Key Drivers of Exchange Rates

When trade in goods and services with other countries was the major determinant of exchange-rate fluctuations, market participants monitored trade flow statistics closely for information about the currency’s future direction. Today, capital flows are also very important and are monitored closely.

When other risk issues are considered equal, those currencies with higher short-term real interest rates will be more attractive to international investors than lower interest rate currencies. Currencies that are more attractive to foreign investors are the beneficiaries of capital mobility. The freedom of capital that permits an organization to invest and divest internationally also permits capital to seek a safe, opportunistic return. Some currencies are particularly attractive during times of financial turmoil. Safe-haven currencies have, at various times, included the Swiss franc, the Canadian dollar, and the U.S. dollar.

Foreign exchange forward markets are tightly linked to interest markets. In freely traded currencies, traders arbitrage between the forward currency markets and the interest rate markets, ensuring interest rate parity.

Theories of Exchange Rate Determination

Several theories have been advanced to explain how exchange rates are determined:

• Purchasing power parity, based in part on “the law of one price,” suggests that exchange rates are in equilibrium when the prices of goods and services (excluding mobility and other issues) in different countries are the same. If local prices increase more than prices in another country for the same product, the local currency would be expected to decline in value vis-à-vis its foreign counterpart, presuming no change in the structural relationship between the countries.

• The balance of payments approach suggests that exchange rates result from trade and capital transactions that, in turn, affect the balance of payments. The equilibrium exchange rate is reached when both internal and external pressures are in equilibrium.

• The monetary approach suggests that exchange rates are determined by a balance between the supply of, and demand for, money. When the money supply in one country increases compared with its trading partners, prices should rise and the currency should depreciate.

• The asset approach suggests that currency holdings by foreign investors are chosen based on factors such as real interest rates, as compared with other countries.