Question

What is the main determinant of the volatility of forward market returns?

Answer 1

Aside from factors such as interest rates and inflation, the currency exchange rate is one of the most important determinants of a country's relative level of economic health. Exchange rates play a vital role in a country's level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the most watched, analyzed and governmentally manipulated economic measures. But exchange rates matter on a smaller scale as well: they impact the real return of an investor's portfolio. Here, we look at some of the major forces behind exchange rate movements.Before we look at these forces, we should sketch out how exchange rate movements affect a nation's trading relationships with other nations. A higher-valued currency makes a country's imports less expensive and its exports more expensive in foreign markets. A lower-valued currency makes a country's imports more expensive and its exports less expensive in foreign markets. A higher exchange rate can be expected to worsen a country's balance of trade, while a lower exchange rate can be expected to improve it.