How are Forex Rates Calculated?
Description: The article looks at the manner in which forex rates are determined.
There are various factors that affect forex rates and the method of calculation of their value.
Do Commodity Price Fluctuations affect Forex Rates?
In the forex market, there are many factors that affect currency valuations and cause them to move up or down. Some of these factors include supply and demand, political conditions, economic growth and interest rates. In general, the more dependent a particular country is on its primary industry, the stronger the tie-up between the industry commodity price and the currency of the country. There is no standard rule to determine which commodities a particular currency will be linked to, and the strength of the link. There are certain currencies that provide excellent examples of forex to commodity links.
Consider the correlation between the oil price and the Canadian dollar. As the oil price rises, the Canadian dollar will generally appreciate against all other major currencies. This is related to the fact that Canada is a highly-ranked oil exporter and, when the oil prices are at a high level, the country’s revenue from the oil exports increases, hence the country’s currency is given a boost as far as forex rates are concerned.
A further example can be made with the Australian dollar and its link to gold. Australia is one of the largest gold producers, globally; hence, the Australian dollar moves at the same rate that the price of gold bullion changes. When the price of gold sees a significant hike, the Aussie dollar will also see an appreciation against all the other major currencies.
How is the Forex Rate Linked to Supply and Demand?
The foreign exchange spot rate is determined by demand and supply. Banks located all over the planet are constantly selling and buying various currencies to satisfy the requirements of their clients, and this creates the forces of demand and supply that affect currency rate fluctuations.
One example is where a South African bank receives a deposit from a Portuguese bank whose client wants to make a purchase from a business in South Africa. The Portuguese client is required to pay the South African company in SA rand, which means that the euros from the Portuguese client need to be converted to SA rand. The Portuguese client will request that his bank exchange his euros to rand and transfer that amount to the South African supplier. If the Portuguese bank does not have enough rands to cover the transactions, they will have to purchase rands from a bank that can cover the exchange, and sell the euros for the exchange.
This transaction indicates that the sum total of all the banks buying rands and the banks selling rands will create a supply and demand for South African rand. If the demand is high and increases, the SA rand will rise against other currencies. Conversely, if the demand drops, the rand will depreciate.
The forex rate is set by the constant asking and offering of various currencies all day long. This is called the interbank system, and reflects the manner in which currencies are traded, and this is the manner in which the exchange rates are ultimately determined.
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