The business of foreign exchange may look as simple as it is but it is not. Like any other businesses, there are lots of factors to be considered in order to ensure its success. Likewise, in the business itself, there are lots of factors to consider on why we have varying rates from time to time.
This is because of the effect of these factors. If taken into consideration wisely, we can make use of the concept of these to determine when the business will be good and when will it be bad for us. That way, we are aware on when we are going to make our moves toward foreign exchange business.
The factors aforementioned above includes:
(a) International parity conditions; purchasing power parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world.
(b) Balance of payments model. This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account deficit.
(c) Asset market model views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the
exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.”
These factors are really important especially in determining the rates in foreign exchange. This is great because if we are aware of these factors, we can make use of them for our advantage. Other factors include economic and political conditions as well as market psychology.