Table of Contents

Lesson 4: Exchange Rates & Supply and Demand

4.3 Factors that Affect Supply and Demand

A variety of actors cause currencies to experience changes in supply and demand:

  • companies that export and import,
  • foreign investors and banks,
  • speculators who wish to engage in market activity,
  • and central banks that control the movement of interest rates.
Who Comprises the Forex market?

Due to its vast volume and large number of participants, no individual or single company has complete control over which way the market will sway. Historically, Forex has been dominated by commercial banks, money portfolio managers, money brokers, large corporations, and very few private traders.

Lately this trend has changed. While there are many reasons for participating in foreign exchange including facilitating commercial transactions, corporations converting its profits, or hedging against future price drops, more and more people are getting involved in the market for the purposes of speculation.

Exporting and Importing Companies

Large multinational corporations influence the foreign exchange market as they purchase and sell goods and materials between different countries.

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The first group that has influence in the foreign exchange markets is typified by large, multinational corporations. Imagine a New York City firm exports its products to a German company. The business transaction will be settled in dollars so the American firm obtains revenue in its own currency and can pay its employees’ salaries in dollars.

To facilitate the transaction, the German firm needs to convert some of its capital from euros to dollars on the foreign exchange market. The supply of euros increases leading to an appreciation of the dollar and depreciation of the euro. It can also be said that the German firm increases the demand for dollars, again causing the dollar to appreciate in comparison to the euro. This transaction would have to be for a very large contract in order for the exchange rate to actually move a pip up or down.

If the payment by the German company is coming 6 months later, it introduces the risk that the amount of dollars they would receive for a certain amount of euros today will not be the same in 6 months time. A company may want to limit, or hedge, this exchange rate risk by immediately converting their euro into dollars, or by purchasing forward contracts in the foreign exchange market. A forward contract is a contract to convert euros into dollars at a future date at a set price.

Importing companies affect the demand of a currency as well. For example, an American retailer features Japanese furnishings and pays its suppliers in Japanese yen. If consumers like these products then they will indirectly contribute to an increase in demand for the yen as the American retailer will have to buy more merchandise from Japan. As the retailer purchases the yen and sells the dollar on the exchange market, the yen appreciates.

Foreign Investment Flows

Foreign investment has many aspects, having to do with goods, services, stocks, bonds, or property. Suppose a Canadian company wants to open a factory in America. In order to cover the costs of the land, labor and capital the firm will need dollars. Suppose the company holds most of its reserves in Canadian dollars. It must sell some of its Canadian dollars to buy US dollars.

The supply of Canadian dollars on the foreign exchange market will increase and the supply of US dollars will decrease, which causes the US dollar to appreciate against the Canadian dollar. On the flip side, foreign investors are also increasing or decreasing the demand for the currency of the country in which they are interested in investing.

Banks

www.cmsfx.com The Federal Reserve For a long time the foreign exchange market has been associated with the term “interbank” market. This term was employed to capture the nature of the foreign exchange market when it predominantly dealt with banks. Banks included central banks, investment banks and commercial banks.

  • Examples of central banks include the Federal Reserve Bank of the United States or the European Central Bank.
  • Investment banks include those of Goldman Sachs, JP Morgan, and Bank of America.
  • Today, banks are not the only participants within the foreign exchange market. With the onset of technology and the growing ease of accessibility to market activity, there has been an increase in many non bank participants such as individuals.
Speculators - Investment Management Firms, Hedge funds, and Retail Traders

Many financial institutions use currency exchange as a method to generate income. There are also many individuals who try to do the same thing. The currency markets move in one direction only when many investors act together. An individual investor cannot move the exchange rate of a currency but many traders, investment funds, and banks may collectively move it.

If speculating traders think the Japanese Yen is going to weaken in the near future due to poor economic data or a change in interest rate policy, then they sell the yen on the foreign exchange market relative to another stronger currency. The supply of yen will increase and cause the currency to depreciate. If many investors feel that a particular currency will depreciate in the near future, their collective selling of that currency will move its price down. Similarly, if speculators feel that a currency is going to appreciate in the near future then they will buy that currency today and cause it to experience a higher demand which causes its price to go up. Investors help materialize their predictions by acting in a herd mentality, and in some peoples eyes bring about a self fulfilling prophecy.

On the next page we expand our discussion of central banks and their role in the financial markets.