How are Forex rates determined in the Forex markets?
We have seen earlier that in the absence of a common measure of value, the value of one currency has necessarily to be expressed in terms of another currency. If the euro/USD rate is 1 Euro = $1.5000, in order to buy 1 Euro, I have to pay $1.5000. This is called a currency pair and if I buy one currency, I am selling the other currency simultaneously. The question that needs to be addressed is how exactly these rates are determined.
As we have seen, the foreign exchange markets are complex and tend to be moved by a number of economic factors such as balance of payments, inflation expectations and interest rate differentials. Prices are essentially set by the same forces of supply and demand that set prices in any market but the manner in which these forces operate can be quite complicated. At the end of the day, we do know that if demand exceeds supply, the price of a currency will rise while an excess of supply over demand will cause the price to fall.
Economic theories of exchange rates: there are many people who believe that the exchange rates quoted in the forex markets are not in line with what the rates should actually be. In fact, there is a great deal of suspicion in the US that the Chinese have continuously manipulated the rate of the Renminbi to the US dollar to boost their exports and balance of payments. The three major theoretical base of determining exchange rates are briefly described below:
-Purchasing Power Parity (PPP): the underlying assumption is that the same amount of currency should be required anywhere to buy a specific basket of goods and services. The major drawbacks of this theory are:
a) The comparative advantage of countries in producing certain types of goods and services are ignored and
b) International capital flows, which have a powerful influence on exchange-rate movements at are completely ignored.
-Fundamental Equilibrium Exchange Rate (FEER): this is theoretically the exchange rate at which a country can operate a current-account balance that can be sustained. Thus, proponents of this theory argue that the growing current-account surplus of China is evidence of exchange rate manipulation. This theory ignores the fact that a country could be running a growing current-account surplus because it is an attractive investment destination. It also ignores countries like Japan which have had rock bottom interest rates for a long time and are attractive currencies in which to borrow.
-Behavioral Equilibrium Exchange Rate: this theory postulates that whatever economic variables influenced exchange-rate movements in the past will do so again in the future. Fair enough, though it does leave you with the problem of identifying the specific variables and the weightage to be given to each one.
Probably the easiest way to understand how exchange rates are fixed is to realize that the rates are set by the interbank forex trading market which is the dominant trading market for currencies. Even the retail trades and forex brokers, like easy-forex, positions tend to get carried into the interbank market. If you look on the banks as the intermediaries that balance supply and demand of currencies, you will have a better understanding. No one bank can set a price that is out of line with the market as arbitraging will, sooner or later, force the price into line with the market.
