SOURCES FOR CURRENCY DEMAND ON THE FX SUPPLY

The currency of a growing economy with relative price stability and a wide variety of competitive goods and services will be more in demand than that of a country in political turmoil, with high inflation and few marketable exports.

Money will flow to wherever it can get the highest return with the least risk. If a nation’s financial instruments, such as stocks and bonds, offer relatively high rates of return at relatively low risk, foreigners will demand its currency to invest in them.

FX traders speculate within the market about how different events will move the exchange rates. For example, news of political instability in other countries drives up demand for US dollars as investors are looking for a ‘safe haven’ for their money. A country’s interest rates rise and its currency appreciates as foreign investors seek higher returns than they can get in their own countries. Developing nations undertaking successful economic reforms may experience currency appreciation as foreign investors seek new opportunities.

Traders in the foreign exchange market make thousands of trades daily, buying and selling currencies while exchanging market information. The $1.2 trillion that is needed everyday may be used for varied purposes:

• For the import and export needs of companies and individuals
• For direct foreign investment.
• Political developments;
• To profit from the short-term fluctuations in exchange rates.
• To manage existing positions
• To purchase foreign financial instruments

In the volatile FX market, traders constantly try to predict the behavior of other market participants. If they correctly anticipate their opponents’ strategies, they can act first and beat the competition.

Traders make money by purchasing currency and selling it later at a higher price, or, anticipating the market is heading down, selling at a high price and buying back at a lower price.

To predict the movements of currencies, traders often try to determine whether the currency’s price reflects its fundamental value in terms of current economic conditions. Examining inflation, interest rates, and the relative strength of the country’s economy helps them make a determination.

• If the currency is underpriced, then the price will go up
• If the currency is overpriced, then the price will go down