What determines Forex prices?

what causes FX price movements

The economists’ theory argues that the rule of purchasing power parity (PPP) is the simplest way to explain exchange rates. The average price of a basket of goods in different countries will explain the exchange rate between two currencies. For example if I can buy 1 basket of goods in the United States for $20 and buy the same goods in the UK for £10 then the exchange rate should be $2:£1. Market forces ensure that this equilibrium point is always maintained.

Inflation rates also have their say. If for example UK inflation was higher than US inflation the US will buy fewer goods from the UK as they will be more expensive to import into the US. Again market forces should take this into account eventually and will move the exchange rate to the US’s favour meaning that eventually the prices will move until the cost for the Americans is the same.

In addition the higher inflation in the UK will dissuade foreign investment from countries such as the US. In order to attract such investment the UK government will have to raise interest rates. This so called ‘monetary policy’ will eventually compensate for the higher inflation and this should be reflected in the forex rates moving back to their equilibrium point.

Increasingly computerization and the spread and speed of the Internet have meant that it has become much cheaper and more accessible for the private individual investor to play the forex markets. Despite this however a large proportion of the forex markets are dominated by the large investment banks such as Deutsche bank and Goldman Sachs. Their scale means they can benefit from large economies of scale and invest in computerization to allow further growth and add value to their customers.

Inflation and interest rates are explicitly linked. You cannot consider one without the other.

Another factor that does have a big effect on force prices is the balance of payments of each country. Put simply this is the difference between the value of goods or services a country buys in or imports vs those it sells abroad or exports. If a particular country has a constant deficit on its payments (it imports more than it exports) it can be thought of as uncompetitive and one could expect the currency of that country to weaken.

The above are economic theories to explain the forex price movements. They assume a perfect market where all information is known by all market players so they can act on it and as a result market prices fully reflect reality. Virtually all economists will admit that even the forex market (the most liquid in the world) is not that efficient.

Information is never fully known by all market participants, no basket of goods can encompass all goods in all countries and spending habits vary the world over. All of these are reasons why to some extent these theories need to be taken with a pinch of salt. Traders that spend most of their analysis looking at these economic factors in order to guess future price directions are said to study the fundamentals.

The final factor to consider when looking at what effects forex prices is one that exists in every financial market – the psychological factors. All markets are said to suffer from herd mentality where speculative bubbles form and investors simply jump on the bandwagon to avoid missing out on what they expect to be easy profits. This effect often causes the markets to over price pieces of news only for prices to fall back to their equilibrium a short time afterwards. Chartist or Technical investors tend to study more on the patterns of such price movements and aim to use these historical price trends to predict future movements.