Introduction to Forex Trading Part 4: Pricing and Rate Setting

The foreign exchange market is by far the largest, most liquid financial market in the world, with average daily turnover exceeding $4.5 trillion as of the end of 2011. Due to its size and liquidity, it can be a great place for traders to start acting on global-focused theses. However, it is important to know how exchange rates are set and what determines them.

There are many different theories as to which factors are responsible for exchange rates. It is likely that the real answer lies in a combination of them all.

First, it is important to distinguish between freely-floating, fixed, pegged, and hybrid exchange rates. The exchange rates of freely-floating currencies vary against those of other currencies and are determined by the market forces of supply and demand.

On the other hand, currencies that are pegged are manipulated by a government agency that is forced to continuously buy or sell currency, in order to keep the currency's exchange at a fixed level. These pegs can take a softer form, such as the Chinese renminbi (yuan), which is allowed to float within a range.

Some countries peg their currencies to boost exports and maintain a current account surplus. For example, the U.S. Treasury Department has asked the Chinese government to allow the yuan to appreciate so as to make American exports more competitive and reduce China's current account surplus.

Prior to 1990, the prevailing theory of exchange rates was based on interest rate differentials. The theory, known as the Uncovered Interest Rate Parity, states that, as interest rates rise, currencies depreciate so as to prevent arbitrage. However, since 1990, the opposite effect has been seen. As one nation's interest rates rises relative to those of another nation, investors take a position in the currency with higher rates. After buying the currency, investors invest the money in a bank account and can receive a higher rate on those deposits.

The sensitivity of exchange rates to interest rates makes central bank decisions important in setting exchange rates. Rate cuts or hikes will create trading opportunities and traders should be aware of this.

Another theory states that exchange rates will always revert to equilibrium in the long run. This model, known as the Balance of Payments Model, assumes that current account deficits or surpluses are responsible for rates. For example, if a nation runs a current account deficit, its foreign exchange reserves will start to deplete as it is importing more than it exports. Eventually, this will cause its currency to devalue until exports are more competitive. The exchange rate will find equilibrium once the current accounts net out.

With the growth of global financial markets, exchange rates have become less dependent on economic factors such as current accounts and fluctuate based more on simple supply and demand. The Asset Market Model assumes that the expansion in trading of financial assets (stocks and bonds) has reshaped the way analysts and traders look at currencies. The rise of pure trading in forex markets, not just exchanging for economic purposes, has made forex markets move more in line with other financial markets.

In the past few years, central banks around the world have turned to printing money in attempts to reflate the economy and prevent deflation. The printing of money increases its supply, and traders commonly believe that this leads to devaluation. Further, some postulate that it is not just the outright printing of new money that affects rates, but the relative amount. As the chart below shows, the ratio of the Fed's balance sheet to that of the ECB's balance sheet has tracked the EUR/USD exchange rate rather well. This suggests that as the Fed eases more than the ECB, the EUR/USD rate rises, and vice versa.

As currencies continue to shift into a pure financial assets, economic factors will have less and less of an effect on exchange rates. Economic factors, financial factors, and interest rates all affect currency exchange rates. The most important attribute is the ability to focus on relevant information.