Forex Currency Trading: How forex rates are determined?–1

Since last one year, the dollar is consistently weakening, not only against the rupee but also with the other currencies in the world. Hence, the rupee is getting stronger. Ultimately, you get fewer rupees for every dollar as compared to what you use to get 1 year before. Just one year back, every dollar use to give 45 Rs. Today, every dollar is only worth 39 Rs. What changes the forex rates and how the forex rates are determined?

In this article, I will try to answer some such questions.

Though there are various theories that explain about how foreign exchange rates are determined, the simplest approach at the root level is the “Purchasing Power Parity”.

Suppose that a basic ingredient of food, like a Potato, may cost 20 Rs. for a kilo in India. And, the same 1 kg potato may cost half a dollar in USA. Hence, for the same quantity of a commodity of purchase, the values in 2 different currencies should have equal purchasing power.
Therefore, by simple mathematics,
20 Rs = ½ dollars
=> 1 dollar = 40 Rs.

The above is the root cause explanation of the movement of forex rates. It again relates to the efficient market hypothesis. If say, that potatoes are available for only Rs. 10 a kilo in India, while in US, they are available for 1 dollar a kilo. Hence, people will start buying cheaper potatoes from India instead from US. Ultimately, a time will come when the Indian Rupee valued potatoes will rise in price, so that they are at a justified level with respect to the dollar. Then equilibrium will be reached.

However, though the above example looks simple to understand, but the forex market does not work that simply (like with potatoes). Along with potatoes, there are hundreds or thousands of several other commodities that determine the trade between 2 countries. Secondly, one commodity may be a necessity in one country, while useless in other. For example, an air cooler is required in hot weather of Rajasthan, but not in New York. The world looks at Vietnam for pepper production, at Australia and South Africa for Gold, at Middle East and Nigeria for Oil. Hence, it all depends upon the trading activities and the price of forex money keeps moving so that the trade deficit is compensated for.
Thirdly, the world is an open market – not just between 2 countries. Coffee is a major produce of Brazil, China as well as India. However, coffee is required all over the world. Hence, the market rates of coffee are determined in open markets where major countries compete, which again ultimately depends upon the forex rates. It’s a recursive process - The rates of commodities forces the forex prices, and the forex rates move the commodity prices, and the cycle continues but not necessarily in that order. It depends upon the demand and supply curve of all the commodities, currencies and how the economy is performing. Ultimately, RANDOMNESS RULES.

More reasons for Forex prices to move: Continue to Part II