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It is important to know the fundamentals of currency differentiation when trading this market. There are many opportunities to make healthy profits trading the worlds currencies if one is astute and knowledgeable.

Interest rates and their effect on currency.

Interest rates play a fundamental role in determining the particular strength or weakness of a currency in relation to its competitors. Currencies may strengthen or weaken based on the real rate of return achieved when investing in a currency. Hence two currencies with similar risk profiles will have different values if their real interest rates differ substantially. One would expect a currency to strengthen on the back of an interest rate hike, as the hike offers investors higher returns. The converse should happen when interest rates fall. Interest is also a tool used to combat inflation in a lot of countries. Reserve banks will keep interest rates real in an endeavour to curb expenditure and drive down inflation.

Risk and the effect on currency

Risk plays an important part in the value of a currency. Investors will demand a higher return on their investment to counterbalance their perceptions of higher risk. Therefore the higher the risk of a currency the more it will be discounted to offer a higher return. Risk will be determined by a countries political and economic stability. Countries with high risk will have to offer substantially greater returns to maintain their currency value.

Inflation

Inflation has the effect of eroding ones currency value if it is running higher than the competitor currency. Therefore one would expect a currency to appreciate or depreciate in relation to its inflation differential when compared to a basket of currencies. Countries with high inflation will also tend to have high interest rates. High Inflation is a economic risk indicator and can lead to currency weakness.

Fundamentals of the underlying economy

The particular buying power of a currency can be seen as a vote of confidence or non confidence in ones economic policy. The stronger currencies are those that are based on sound economic fundamentals. Oil rich currencies will appreciate in oil booms. Great manufacturing countries will appreciate in times of boom. Those countries with high growth rates, low inflation, and sound market practices will have good fundamentals and a sound currency value. If a countries economic fundamentals are sound then one would expect a long term appreciation of the currency.

Export rich countries

Countries that rely heavily on exports to drive their economy will prefer to have a weaker currency in order to make their exports more competitive. This is especially true in large manufacturers such as China. The governments will often intervene to keep the value of their currencies low in relation to their major trading partners. They will do this by manipulating interest rates and money supply, and purchasing competitor currency to keep the value high.

Import countries

A lot of developing countries are net importers due to their weak manufacturing economies. They are very susceptible to import inflation and have a desire to keep their currency strong. These countries will tend to have economies with relatively high interest rates and high inflation. Their economic risk is also high.

Short term manipulation of the market

Currencies are tradeable entities. Therefore they are subject to daily manipulation by marketeers and speculators. There are thinly held currencies that are easily moved in one direction or other by very small trades. There is always money to be made on volatility and traders often move currencies up or down to make short term profits. However in the long term currency fluctuations are usually based on economic fundamentals.

The forex market is based on the normal rules of demand and supply. Those currencies in demand will tend to appreciate over time. Those that are oversupplied will depreciate in value. One has to be aware of all the factors discussed above in making an informed decision on currency investment. The above are mere indicators as to how a currency is valued.