What factors affect Foreign Exchange pricing?

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Posted on March 30, 2023
What factors affect Foreign Exchange pricing?
A deep dive into what makes numbers switch from green to red multiple times a minute.
OpenPayd Editorial Team
OpenPayd Editorial Team
March 30, 2023

If you’re a business that’s using more than one currency, changes to the exchange rate will be having an impact on your operations – whether you want them to or not.

As individuals, none of us have much control over foreign exchange rates. But understanding why the rates are what they are, and the factors that impact their fluctuation can help you when it comes to purchasing foreign currencies.

When making that decision there are two categories that factors fall into: market forces and brokerage fees. Let’s dive in.

Market influences

The foreign exchange markets are a land of giants. Your local supermarket importing American whiskey isn’t going to do much to change the value of the dollar. Booking a holiday to Sharm El-Sheik won’t be driving up the Egyptian Pound.

These factors do play a very small part, but when we’re talking about changes in value between different currencies, prices are being driven by high-value, high-volume transactions between major financial institutions and central banks. And behind many of those transactions are changes in the macroeconomic landscape, in the rate of inflation and in the economic performance of different countries.

Inflation

Inflation is simply the change in prices for goods that occurs over time. But what’s most relevant for us is that inflation isn’t uniform around the world; different countries experience different rates of inflation, which shapes how appealing a country is for foreign investors. As a very simple rule of thumb, if a country has a high rate of inflation, investors are more reluctant to hold that currency or make local investments, as they will have less purchasing power and higher costs over time than a country with lower inflation.

For example, an investor looking to invest in a new construction company may think twice if the company is seeing double-digit inflation in the price of raw materials like concrete and steel. They might prefer a construction company based in a country where those prices are stable or increasing at a slower rate. As different countries experience different levels of inflation, investors shift investments accordingly, which affects the price you’ll pay in the FX markets.

Interest rates

Then there are interest rates, which are one of the first things central banks adjust in order to temper the aforementioned inflation. When a central bank raises interest rates, it makes it more attractive to buy and lend that currency, as the rate of return for many financial products increases in line with the central bank’s base interest rate. It also makes saving in that currency more attractive as more can be gained through interest.

Just as inflation won’t play out in the same way across every country, central banks won’t respond to inflation in the same way either. Imagine two central banks for Country A and Country B have set roughly the same interest rate. Then over time, Country A’s central bank increases their base rate to fight inflation. As a result, Country A may see inflows of capital from Country B as investors chase the more appealing returns on from assets like government bonds.

Political stability

Currency markets don’t like what they don’t know. In times of political turmoil, investors can’t be sure what will happen with a country’s economy – if the government will default on its debt for example, or if there will be restrictions on moving money in and out of a country. At the most extreme end, political instability might turn into political violence which damages or destroys capital invested in the country.

Any political instability will usually have a quick impact on FX markets, as investors holding the currency look to sell and fewer investors are willing to buy, dragging down the exchange rate. Even just the loss of tourism that can come from political instability can suck demand out of the FX markets as people stop buying the local currency for their next holiday.

Imports and exports

The imports and exports of a country play a big role in determining the price of its currency. If the value of a country’s exports rises relative to their imports, their currency’s value may also increase as more money flows into the country from abroad.

On the other hand, if a country is importing more than it is exporting, it may well have to borrow funds from foreign sources to cover the difference, which may devalue its currency over time.

Public debt

It is not uncommon for governments to amass public debt in order to fund day-to-day expenses and large public investments. These spending decisions, and the bonds that the government issues to pay for them, can all indirectly affect currency markets.

Imagine our aforementioned construction company that’s facing higher prices for cement and steel. One reason for those higher prices might be because the government has borrowed a lot of money from international investors and used that to build bridges, airports and other infrastructure projects.

That extra activity in the economy pushes up demand for raw goods like cement. If supplies can’t rise to match, our construction company is going to face inflated prices for those goods.And if that inflation is playing out right across the economy, it’s going to start affecting demand for the currency.

On the other hand, rising interest rates will increase the cost of borrowing for governments, potentially making their bonds more appealing for investors.

Currency liquidity

Large currencies such as USD are traded so frequently that it is not easy for an individual buyer or seller to cause a large fluctuation in the price. There are lots of dollars in circulation, with lots of potential buyers and sellers, and lots of brokerages with large books of buy and sell orders. But this dynamic isn’t as strong for smaller, less liquid currencies.For these smaller currencies with shallower currency markets, individual buy and sell orders have greater potential to move the market.

This means less frequently traded currencies can see their value increase or decrease rapidly if they suddenly experience new demand (or conversely, if the holders of that currency decide to sell), simply because the market for those currencies isn’t as deep.

Brokerage fees

Everything we’ve covered so far are macroeconomic factors that shape the FX markets. But the second element to the prices you see when buying another currency is the fees from the FX broker you are buying from. These fees can come in various forms.

As a business, you may be charged a cross border commercial payment fee to allow you to receive international payments. Then there is potentially a transaction fee every time you make or receive an international payment – this fee will differ depending on the currencies involved in the transaction.

Some FX providers will pride themselves on operating without fees. However, this is not always what it seems, as they will simply build their fees into a highly unfavourable exchange rate.

What does this mean for my business?

If you are regularly buying materials from a supplier in a different country, paying a developer team working abroad, or simply looking to accept payments from customers in multiple countries, you’ll be relying on an FX service from your banking partner.

For example, let’s say you’re a digital investment platform that wants to expand internationally. You are going to need to be able to accept a variety of currencies so your customers in different locations can invest with their own currency, and be able to pay out in multiple currencies so that the recipients of the invested funds can receive them in their preferred currency.

You may even want to give your customers the ability to hold multiple currencies themselves and trade between them. Remittance businesses, for example, may want to expand the number of currencies they offer to their clients, both for sending and receiving international remittance payments. And underlying every one of these payments are the charges you’re receiving from your FX provider.

You’re not going to be able to influence political unrest or a foreign country’s rate of inflation, but you can be clear with any additional fees that come from your FX provider. At OpenPayd, we ensure that our fees are fully transparent at all times with nothing hidden or added on at a later time. Your business and your customers know exactly what they’re getting.

When markets behave in unexpected ways, the most valuable thing you can offer your customers is transparency over what you can control. That’s something we won’t be changing any time soon.