What Causes Changes in Conversion Rates
With the complex conversion rate marketplace and the secrecy of transactions between the larger banks on the market many people wonder what causes the changes in conversion rates. It’s a rather difficult thing to find out if you’re just a low level trader on the market – but it’s a very important thing to figure out if you wish to be able to profit in this market.
The Central Bank Lending Rate
Each currency on the currency conversion market is controlled by a central bank. In the United States this bank is the Federal Reserve, in the UK it’s the Bank of England. The Euro is controlled by the European Central Bank. These banks are very exclusive as the only banks permitted to loan government money. These banks primary job is lending money to a government and creating the currency of that nation.
These banks set the lending rate, also known as an interest rate for their currency. If a central bank raises its lending rate it becomes more attractive for investors to place an investment due to the higher interest rates they will receive and the currency becomes more valuable. For example if the United States Federal Reserve rose its lending rate investors would flock to invest money as they would get a better interest rate on their investment. This is the main thing that affects short range changes in conversion rates.
National Debt
The level of a nation’s debt directly affects the conversion rate of the currency of that nation. For example the United States has a high level of debt – both the government and many large corporations that directly affect our economy. This causes nations and central banks that often invest in the US dollar or use it as a reserve currency to look elsewhere for their needs due to the instability of the dollar. When other nations are not using the dollar as much it loses its value and the conversion rate for the US dollar goes down.
Imports vs. Exports
Another big thing that affects the conversion rate is the amount of imports the country has against the amount of exports a country has. When a country is importing more products then they are exporting it means the gross national product (often referred to as GNP) has dropped substantially. This makes the currency conversion rate for the nation’s currency drop as well.
In the United States the gross national product is down quite a bit compared to previous years. The US is exporting less goods then it is importing. This has caused the value of our currency to go down because the global market is using our currency less.
Purchasing Power Parity
Purchasing Power Parity is a theory presented in the sixteenth century and is the most important factor when determining conversion rates for a country. Purchasing Power Parity of PPP suggests that goods should cost the same in two different nations. If this is not true it would create riskless simultaneous purchase and resale of the same products in different markets. This would increase the value of the currency in the nation where the goods were less expensive and the value of the currency in the nation where the goods were more expensive to drop.
Trade Imbalances
If a trade imbalance exists between two countries it will affect the currency conversion rate between those countries. Let’s say that China is selling a lot of goods to American companies, thus the companies in China will be holding a large amount of American Dollars. American companies would be holding a lot less Chinese Currency. When it comes time to convert that currency the American Companies could demand a much higher conversion rate from Chinese companies due to the law of supply and demand.
Political Stability
A countries government has a huge affect on frequency conversion rates. When the government becomes unstable due to political corruption, a leadership vacuum or other issues people are less likely to be comfortable using those countries currency – thus the value of the currency will fall.
Do Your Research
So if you are thinking about investing in a foreign currency and are researching conversion rates it’s very important that you do your homework. Be sure to research political stability, trade history, the gross national product, and how much control the central bank exercises over that countries economy.