August 23, 2012
Ever exchanged currency only to be left wondering why your money suddenly goes further or, frustratingly, is worth less? Take the pound for example: in 2011, £500 would buy you around €560, a year later you'd get over €630 – a pretty major difference.
But that's the thing with exchange rates, they fluctuate, and despite being based on the very simple economic principle of supply and demand, trying to make sense of their ups and downs can be tricky. And buying currency at the wrong time can prove costly.
So what actually causes exchange rates to move around so much?
This one's a real biggie. Generally speaking (and that's the only way you can really speak about the volatile beast that is the exchange rate), higher interest rates will make a currency stronger. That's because it'll make a country catnip to foreign investors. But before they can snap up that country's stocks or bonds they'll have to purchase lots of the currency in question, increasing demand and making it more valuable. This is what happened in Iceland before the financial collapse - extremely high interest rates attracted a huge influx of foreign investment which pushed up the currency until the Króna became the most overvalued currency in the world!
Of course, it works the other way as well. Back in 2008, the Bank of England slashed interest rates – a move which almost immediately saw the pound plummet in value against the euro, as investors pulled out their cash and went elsewhere.
It's not ALL about interest rates, though. There's also the thorny issue of inflation. The basic rule of thumb is a high rate of inflation can often push the value of a currency down – it means there's too much money in circulation, lowering its purchasing power and its value compared to foreign currencies. Of course, it also works the other way, with lower inflation helping make a country's currency stronger. That's partly because its exports will be cheaper, attracting foreign customers and making demand for its currency shoot up.
The foreign exchange market is just like the stock market, with hordes of speculators buying and selling currencies to make oodles of cash. In doing so, they affect the value of a currency: if speculators think a currency is about to drop in value, they'll try to flog it quickly – that causes its supply to surge up and its demand to lower, and its value will drop.
The most notorious example of this came in 1992 when the British pound's value nose-dived on what has been called Black Wednesday. One speculator, George Soros, made a whopping $1 billion by predicting this drop and borrowing, selling and then re-buying at the cheaper rate, and is still rather fearsomely known as "the man who broke the Bank of England".
All sorts of other factors will interact with interest rates and inflation to affect the overall value of a currency. If there's political uncertainty, investors can get jittery and hold off from buying that country's currency, lowering its value. This actually happened to the pound in the run up to the British general election of 2010. Cut to 2012, and the more stable political situation actually pushed UP the pound, despite the stormy economic climate.
So what's the upshot on all of this? Simply put, even the smartest traders can have trouble predicting the yo-yoing antics of exchange rates. But by keeping an eye on the financial news, you can at least make a bit more sense of when might be best to transfer money abroad or go on your hols.
By Taavet Hinrikus