Question

Identify 3 factors associated with international trade that affect the demand for a currency (and thus its foreign exchange rate).

Answer 1

Factors associated with international trade and thus exchange rates

1.Interest rates of two countries

The difference in interest rates of two countries will affect international trade and exchange rates between two countries. This implies that high interest rate in one country will offset by depreciation of currency of that country. If interest rate of USA is greater than Canada,US dollar will depreciate against Canadian dollar. According to interest rate parity theory, The future spot rate can be calculated using the formula,(1+Rh)/(1+Rf)=F1/Eo

Where Rh=home country’s interest rate,

Rf=Foreign country’s interest rate,

F1=Forward rate of foreign currency

Eo=Spot rate of foreign currency

This difference in interest rate and corresponding anticipated change in exchange rate will affect decision of international trade also.

2.Inflation Rates

Before an international trade,every one will consider inflation rates and corresponding change anticipated in exchange rates.Inflation rates prevailing in two countries affect the trade between those countries and exchange rates between currencies of those countries.In an efficient market, if interest rates of two countries are different, exchange rates between two countries will move in a way that, high interest rate in one country will be offset by depreciation of the currency of that country. If inflation rate of USA is greater than Canada,US dollar will depreciate against Canadian dollar.

There is a link between inflation rates and exchange rates of two countries ,called law of one Price. The law of one price state that the price of commodity shall be same in two markets,else arbitrage opportunity opens up. ,

Forward rate of foreign currency can be calculated by equation,(1+Ih)/(1+If)=F1/Eo

Where Ih=inflation in home Country,

If=Inflation in Foreign country,

F1=Forward rate of foreign currency

Eo=Spot rate of foreign currency

3. Speculation and expectation of market

This is applicable for type of investors who are predominant player in the market.Just as purchasing a share in anticipation or expectation of price rising in subsequent dates,players in foreign trade waiting to seize opportunities to buy or sell commodities and currencies when they think it is available at a bargaining price. When reliable data available, this speculation and expectation theory will work more better.In currency trading

1.Buy a currency which they consider currently weak,but expecting appreciation in future ,and

2.Sell a currency which is currently strong,but expected to depreciate in future