Understanding Fluctuation of Exchange Rates
It’s important to understand exchange rates if you are engaged in foreign investment or international business. In this piece, we’ll examine how exchange rates work.
What is fluctuation of exchange rates?
Exchange rate fluctuations occur when foreign currencies undergo changes in value. Because each currency’s value changes due to a variety of economic factors, any currency can be bought or sold for a different amount of another currency at any given time.
For example: at the time of writing, the GBP/USD exchange rate was 1.22, meaning that investors who sell £1 receive $1.22 in return. Conversely, the USD/EUR exchange rate was 0.81 at the time of writing, meaning that investors who sell $1 receive just £0.81 in return.
Exchange rates fluctuate constantly. As a result, investors can take advantage of rate changes by waiting for a particular currency to become stronger or weaker. Conversion fees and other charges may additionally affect the actual amount involved in any transfer.
Factors Influencing the Fluctuation of Exchange Rates
There are several factors that can cause exchange rates to fluctuate. Any factor that causes a currency to gain or lose value can result in noticeable fluctuations.
Economic performance
Countries with a strong economic profile generally create increased demand for their local currency, which in turn drives up the currency’s value. A country’s economic performance can be measured in various ways including gross domestic product (GDP).
Inflation and interest rates
Inflation can affect the value of a currency. Low inflation generally strengthens a currency’s value, while high inflation generally reduces a currency’s value.
Interest rates can also have a related effect, as many countries raise interest rates to combat inflation. Higher interest rates generally increase a currency’s value as well.
Trade balances
Trading balances, or the degree to which a country engages in importing and exporting, can also affect exchange rates. Once again, this is due to demand for a country’s local currency.
Countries that produce a large amount of exports often experience heightened demand for their local currency, which strengthens that currency’s value. Countries that rely heavily on imports generally see less demand for their currency, which weakens the currency’s value.
Stability of a country
More stable countries generally attract greater foreign investments, which can in turn strengthen the local currency’s exchange rate. Perceived stability may concern factors like elections and leadership changes, policy shifts, general welfare, and economic conditions.
Market expectations
Market expectations can affect exchange rates as well. These expectations can be influenced by financial agency meetings, economic data, and general trends among investors. Ultimately, any information can influence investor sentiment.
Changes in expectations and market sentiment can cause currency holders to buy or sell a foreign currency. If the resulting trading activity is widespread enough and concerns enough value, it can significantly affect the exchange rate of the currency in question.
Currency's Impact on the Economy
Currency fluctuations are not just the result of economic conditions. The strength of any given currency can also have a profound effect on a country’s economy.
Merchandise trade
Currency exchange rates can impact the economy by affecting a country’s ability to engage in foreign trade. If a country has a weak foreign currency, it may find itself in a situation where imports are less affordable and exports are more affordable.
On the other hand, if a country has a strong foreign currency, it may be able to easily afford imports, but it may find exports to other countries quite expensive.
Economic growth
Exchange rates can affect a country’s economic growth. Contrary to what one might expect, a strong local currency can slow down GDP growth and economic growth. This is because a strong local currency encourages individuals and businesses to spend that currency in foreign markets, where the currency has even greater buying power.
Capital flows
The value of a country’s local currency can affect capital flows because countries need reasonably stable currencies to attract capital from foreign investors. Capital flows may come in the form of foreign direct investment (FDI) or foreign portfolio investment.
Inflation
If a country’s local currency has a relatively low value, it can experience a type of inflation called “imported inflation.” In this case, anyone using a currency that suffers from weakened buying power must spend more of that currency in order to import goods.
Interest rates
Exchange rates can affect how countries set monetary policies, including interest rates. Additionally, strong domestic currencies can create higher interest rates by affecting the economy directly, causing an effect that is similar to tightened monetary policies.
Fluctuation of Exchange Rates Case Studies
In this section, we will consider how various foreign currencies have fluctuated over time.
GBP Pound Fluctuation
The British pound has existed for hundreds of years and has undergone continuous changes, but certain events in modern history have largely determined its value.
Those key events include the adoption of the gold standard in the 1700s and 1800s and the abandonment and reintroduction of the same standard throughout the 1900s. The UK finally abandoned the gold standard in 1931, greatly affecting the amount of money in circulation and, by extension, affecting the price of the British pound.
In more recent history, various crises and successes have caused the pound to suddenly lose or gain value. Notable events include Black Wednesday in 1992, the emergence of the competing euro in 1999, and Brexit in 2016. Global events such as the financial crisis of 2008, World War I and II, and COVID-19 have also caused fluctuation in exchange rates.
GBP reached an all-time low against the U.S. dollar in September 2022, at which point it was worth just $1.03. This occurred after the UK government introduced sweeping tax cuts.
The British pound has also reached all-time highs at various points in recent history. On most of those occasions it was valued above or close to $2.50. However, GBP’s saw its highest value in the 1800s during the U.S. Civil War, when it was valued at roughly $10.00.
USD Fluctuation
The U.S. dollar originated in 1792. It has been affected by many of the same factors as the British pound, including varying recognition of the gold standard. The U.S. adopted the gold standard in the 1870s and finally abandoned the standard in 1971.
Other specific events that have affected the value of USD include the 1907 Bankers’ Panic, the Stock Market Crash of 1929 and the ensuing Great Depression, the 1980s stock market bubble, and various wars. The 9/11 attacks and the “dot com” bubble in 2001, the 2008 financial crisis, and the COVID-19 lockdowns have impacted the dollar as well.
The USD exchange rate is generally measured through the U.S. Dollar Index, which takes into account several currencies instead of just one currency.
Measured by that index, the U.S. dollar reached its all-time high of 164.72 in 1985 around the time of the Plaza Accord, where international finance ministers gathered to manage fluctuating rates. USD also reached a 20-year high of 110.05 in September 2022, an event that occurred amidst the end of the COVID-19 pandemic and rising interest rates.
USD reached its all-time low of 70.698 amidst the 2008 financial crisis, and alongside various pieces of legislation that the U.S. government created to counteract the crisis.
Euro Fluctuation
The euro is much younger than USD or GBP, but it has nevertheless undergone several significant events since it was introduced in 1999.
€1.00 was worth roughly $1.17 in U.S. dollars in the first days of trading, but by the end of 1999, the euro had reached parity with the U.S. dollar. The value of the euro continued to decline and it hit its all-time low of $0.82 in 2000 amidst efforts to strengthen its value.
Since then, the euro has seen various ups and downs due to various developments including policy decisions from the European Central Bank and key global events. The euro reached its all-time high in 2008, at which time it was worth $1.60. This occurred during the U.S. financial crisis and amidst the European Central Bank’s own interest rate increases.
It should be noted that some sources project the euro’s price value to dates that are earlier than its launch. This seemingly is due to the fact the euro replaced an earlier accounting currency called the European Currency Unit (ECU), or due to synthetic price models.
Investing Strategies in a Fluctuating Currency Market
It is possible to make strong investments even when currency fluctuations pose a challenge. If you plan to invest in a fluctuating currency market, consider these strategies:
Overseas investments
International or overseas investments allow investors to invest in foreign real estate or other assets that experience growth separately from currency strength. Though fluctuating exchange rates can still affect returns on one’s investment, careful consideration can make this strategy useful for those looking to invest in a fluctuating currency market.
Tapping into U.S. Multinational Companies
Many of the top publicly traded companies such as Apple, Microsoft, Google, and Amazon are American multinational companies. By investing in stocks or shares of these companies, your investment may perform independently of the value of any global currency.
Currency Borrowing Caution
As with all borrowing, you will need to repay debt if you borrow foreign currency. However, foreign currency makes debt repayment even more difficult, as any currency can gain value. In other words, you might need to repay extra value on top of regular interest.
Risk Mitigation
There are various ways to reduce foreign exchange risks. You can engage in hedging, use foreign currency bank accounts, create arrangements and contracts, and rely on your local currency when it is possible to do so. Read more in our risk management blog post.
Conclusion
Exchange rate fluctuations are both caused by and affected by economic trends. Leading world currencies often have long histories and are continuously affected by countless global events, meaning that predicting currency fluctuation is a challenging task.
Fortunately, there are strategies for investors who are working with foreign currency and investments. Through those methods, one can make the most of market conditions.
Additional Resources
If you are investing in or spending foreign currencies, it is important to get the latest exchange rate data. Many regions provide exchange rates through their central bank. See:
- The Bank of England’s pound sterling page
- The U.S. Federal Reserve’s foreign exchange rates page
- The European Central Bank’s foreign exchange rates page
- The Bank of Canada’s exchange rate page
- The Bank of Japan’s daily foreign exchange rates
Exchange rates are often available through secondary sources, such as Google and individual forex brokers, as well. However, official sources are the most reliable option.
Payset provides real-time exchange rates on 38 currency pairs and allows trading 24/7, including evenings, weekends, and holidays. Exchange rates are quoted from our trusted partner banks.
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