Why is one currency priced higher than another?

Why is a person willing to exchange 1 unit of a certain currency for less than 1 unit of another currency? Why aren’t all currencies worth the same? Why is the value of one currency in relation to another currency in a constant flux, unless very strong governmental forces act to ensure stability?

The market price of a currency in relation to another currency can be influenced by a multitude of factors, including very ephemeral things such as rumors.

Below, we will take a look at a few tings that can influence the market’s valuation of a currency in relation to another currency. It’s important to keep in mind that the forex market is comprised of a myriad of actors and it is difficult to predict exactly what the net result of all their actions will be. This is why forex trading can be so challenging – and rewarding. Sometimes the market goes against conventional ideas about how it “should” react, and we get to see a price rise in the Euro against the USD when information has been released that, according to a more conventional pricing model, would cause the Euro to fall against the USD, and so on. It is also notoriously difficult to predict how strongly the market will react to news and other forms of input; sometimes a seemingly minor thing sets of a chain reaction that causes huge swings at the forex market.

Three factors that can influence the price of a currency

Three factors that can influence the price of a currency in relation to other currencies are the issuer’s overall economic situation, the issuer’s commercial balance, and the issuer’s political situation. Typically, these factors are intertwined in a complex web.

By issuer, we mean the country or currency union responsible for issuing the currency. Some issues, such as the Swiss franc, is issued by a sovereign state. Other currencies, such as the Euro, are issued by a currency union comprised of several sovereign states.

When the economy of the issuer is doing well, this typically translates into a price rise for the currency. Exactly how to measure if an economy “is doing well” is of course up for debate, and different traders look at different things. One trader might for instance put a lot of stock in GDP and national debts, while another is more concerned with retail sales and data concerning employment/unemployment/underemployment.

What we do know is that when an issuer is doing poorly and for instance is finding it hard to pay its debts, this normally leads to a rapidly sinking valuation of the currency, which in turn tends to worsen the situation for the issuer.

A factor that is considered an important aspect of an issuer’s economy is the commercial balance, also referred to as the net export measured in local currency. Is the monetary value of the issuer’s exports larger than the monetary value of the issuer’s imports? If so, the commercial balance is said to be positive and this typically translates into a stronger currency. If the commercial balance is negative, this is called a trade deficit and it has a tendency to weaken the currency.

It should be noted that if a country has a big trade surplus, i.e. is a big net exporter, they government might not see the strengthening of the currency as a good thing. A stronger currency can make the exports less appealing abroad due to the increased price tag for end consumers. Sometimes governments will actively work to keep the currency weak in order to boast exports. Also, a weak currency make imported products more expensive for the domestic end users, which may in turn opt for buying domestically produced goods instead, thus strengthening the trade surplus further by not importing a lot of goods.

Finally, the political situation of a country tends to impact the value of a currency. Its important to realize that sudden changes (e.g. from excellent to just good) can have a big impact. This means that the price of the currency can sink even though the political situation for the issuer isn’t actually that bad seen in relation to the political situation of other issuers.

In other situations, we suddenly see a huge increase in the price of a currency even though the political situation of the issuer has remained largely unchanged lately – it is instead the political situation for one or several other issuers that have taken a turn for the worse.

Political instability and social unrest, rather than something being bad but stable, tend to generate fears that investors will pull out of the area or avoid making new investments. This in turn tend to weaken the currency.