How exchange rate is determined

I don't mean to put the following question into Forex Beginner Q&A, I know many of us have been trading FX for quite a while, but have you ever asked this question? it's not an easy question though, here it is:

We all talk about interest rate or interest rate differential to be specific, whenever we got a hint that one country is about to raise its interest rate that country's currency will appreciate because we all prefer high return than low yield, so we buy the high interest rate currency. But the interest rate parity tells us that in an world with no arbitrage opportuity the high interest rate currency will depreciate instead of appreicate, mathmetically it's easy to proof (for those who don't know the relationship: http://www.riskglossary.com/link/int...ate_parity.htm). And intuitively let's say central bank raise interest rate in order to control the inflation (that's the key target of monetary policy), so the high interest rate is associated with high inflation, the country with higher inflation should expect its currency to depreciate over time, however what we see now is the ever growing Carry trade which allows high interest rate currency to appreciate over time, NZD/JPY for example.

So the question is that how do you explain the obvious contradiction?

My explanation is that FX market is very speculative so the force behind the exchange rate is not solely determined by the fundamantals. Any other explanations are greatly appreciated. Let's solve this puzzle together.

I agree 100%. All speculative. It's all about what the public "thinks" is cheap or expensive

It is determined by the trillions of dollars per day that flow between banks.

Whoever has the most money to trade will have the most effect on price. Or, more accurately, the greatest flow will have the greatest effect.

One individual trader is like a fly landing on a bridge - the bridge does move. Is there an effect? Not really.

if the export and import of goods is smooth, i think currency fluctuation is good, if the currency price is up, import will be boosted,
if the currency pair is down, export will be boosted,

if the trend is somehow too dangerous to be continued, central bank may widen the spread, so by the spread alone , the nation get income, ..
or give fixed rate...., loan IMF (bad idea), rise import / export tax... ect ect

i feel de ja vu....

I agree... but remember the Butterfly effect

I don't know what that is.

This is simply a relationship for arbitrage free spot and futures pricing. It does not imply depreciation of the higher yielding currency. By that logic – if the futures could predict the direction of the market – none of us would bother trading spot at all.

Rising inflation only makes currencies rise, because the market is betting on the sanity of the central bank to curb inflation by rising its interest rate (target).

The commercial interest rate is determined by the market, though, and not by the central bank directly. It's composed of the nations credit demand/supply, a risk premium and an inflation premium. The central bank can control the money- and credit supply. To reach its target rate, it can use newly created money to either lend it to commercial banks directly, or to buy private or government debt. This means an expansionist monetary policy will initially drive interest rates down and vice versa. As long as there is no widespread inflation expection from the public.

In the long run, supply and demand will determine exchange rates and price levels. That's not to say there can be no speculative, i.e., "bubbly" elements: cheap money can find its way to everything: tulips, gold, oil, stocks, real estate, art, currencies, and in the end general consumer prices. Then the inflation premium on market interest rates will rise.

The equation you are looking at in the link describes the forward rate versus the spot rate for the same currency pair, not the spot rate itself. Ignoring other conditions, under just that formula, the spot rate could actually go wherever it wants; and the forward rate would would simply follow it up or down.

The problem occurs when the interest rate differential is enough to spark - or accelerate - capital inflows (as is going on with NZ atm). You can see sort of the opposite, where Canadian interest rates are below US rates, but the CAD has strenthened quite a bit due to capital inflows from other causes (M&A, energy, commodities, etc...).

Re, inflation per se within a country makes no difference to an external investor, what matters is how that inflation relates to it's currency value Inflation in China (despite whatever authories claim it to be) is going to be pretty high for the average Chinese citizen simply because the growth in consumer demand outstrips the supply ability as the population urbanizes - which puts a fundamental demand on the markets to meet basic living needs (e.g. people are moving from social structures where they built there own houses & raised there own food to a cash economy, where these things have to be bought). Unless China wants to really put on the social brakes hard - which will risk social unrest - they have to accomodate this by printing more money. But it's ccy will continue to strenthen against the USD....

rate expection pricing a-prior.
"buy rumor, sell news."
that is way of markits.

ok, thank you.

But it's not a problem, per se, that capital flows to where it finds the highest gains (per risk). This ensures putting the globally available resources to best use.
It would not be a problem under a market determined, free floating interest rate. The capital inflow would raise the credit supply in the high yield country and bring down its interest rate, conversely the rate in the originating country would rise.
The problem is the fixed interest rate policy, especially in the originating countries.

I'd say what matters is the return of the investment (interest rate) versus the expected future currency value and volatility (inflation).

Are you suggesting printing more currency is causing it to strengthen?
They are printing more to keep it low against the dollar, and to support their low interest rates, which in turn keeps the bubble from bursting. They are also hording the trillions of dollars from the exchange, or at most buying more US debt with it. It's plain old mercantilism.

The reason for the changes in price is...
> supply and demand

the reason for the disparity between interest rates and price...
> supply and demand


When the market has increased liquidity on one side of a pair verse the other it is not always for the same reason. The increased inflow of cash to one side of a pair is based on whatever impulse the buyers have over sellers (and vice versa) that they think will lead them down the easiest path to profit.

Powerful and simple answer KudzuFX.
For some people the "Macro" approach(news, interest rates, etc) is the determinant of the exchange rate. But for me the "Micro" approach(banks, traders, goverments, dealers, companies etc) is the determinant of the exchange rate. They buy or sell according what they perceive. Unfortunately Im not good expressing myself. Can someone contribute to this?

I totally agree that supply and demand is driving prices, but something is driving the supply and demand, too. Isn't it our job to uncover the underlying factors?

It reminds me of the following: some time ago in a midday tv show there was some finance 'expert', and one caller wanted to know: "how is the price of a stock determined?"
My first simple answer would have been: whatever price the two parties trading the stock agree on! But the expert told about the P/E ratio as if it were some magic formula.

I doubt you guys could convince Tom Yeomans that Supply and demand Sets the price

Excellent Analogy.

Market prices are always determinated by the market forces and policy. The market forces are:

Supply and Demand


The goverment manage the policy (fiscal policy and monetary policy) for control of basic macroeconomic variables (growth, inflation, deflation, employment, investment, etc.)

The supply and demand have other significant variables like: EXPECTATIONS.

you should be read Prices theory (microeconomics) for understand Supply and Demand components (market forces), and Macroeconomics for understand monetary policy and trade balance effect over the FX rate.

FX Article :

Did you change the price of a nation's currency today ?

What actually determines the price of an exchange rate at any given moment? It's a "behind-the-scenes" mechanism that Traders need to understand. On the surface, price movement is often seen as a result of a response to economic news, or reactions to key technical levels found in a chart. While this is very true, underneath these two very nondescript and mechanical views operates a much more human set of behavior patterns. Cut open the chest of "The Market" and you'll find it beats with a human heart.
To strip the complexity out of Forex trading, let's imagine that the market is just a room full of people. It's a big room that looks a bit like the inside of your local bank, with two lines of people queued up at a cashier's counter. The counter in this room is the Forex broker's desk, and the two lines of people are the buyers and the sellers.
For the sake of ultra-simplicity, let's name the exchange rate that will be traded in this room the "XYZ". The value of the XYZ is set in big fat round numbers of "$" and means that each "pip" will be a chunky $1. And the FX broker is nice enough to not charge a spread between the "bid" and "offer" price to keep this example super simple. We'll also ignore the number of XYZ that either buyers or sellers are dealing with.
The BUYER's queue is organized so that those buyers willing to buy at the HIGHEST price end up closer to the front of the line, and those willing to buy at the LOWEST price end up at the back of the buyer's line. The SELLER's queue is organized so that those sellers willing to sell at the LOWEST price end up closer to the front of the line, and those willing to sell at the HIGHEST price end up at the back of the seller's line. These rules mean that we now have the opportunity to create a market where willing buyers and willing sellers can meet and trade with each other (via the broker). Now let's watch this market in action.
The first two people in each line standing at the counter will be the first served customers. The first buyer in the line is willing to "bid" $10 for the XYZ. The first seller in the line is willing to "offer" the XYZ also for $10. The broker settles this transaction between the two parties, and the "last price" is registered as the "current price" of the XYZ (at $10). After this transaction is completed both the buyer and seller leaves their queue and the next in line customers are ready to be served.
The next in line buyer and seller line up at the broker's counter and place their orders. This buyer is only willing to pay $9 to bid for the XYZ. This seller is offering the XYZ for a price of $11 - they are unwilling to sell it for less than that. So now we have a standoff - our buyer cannot find a seller that will sell the XYZ for $9, and our seller cannot find a buyer to buy the XYZ for $11. After considering their position, the seller decides to lower their offer price down to $9. The broker again settles this transaction between the two parties, and the last registered price of a settled transaction is now at $9.
If you where watching the chart, you would have seen the official price of the XYZ exchange rate "tick down" by one pip from $10 to $9.
The next seller sees this downtick on their computer trading screen and decides that XYZ is headed south. This "bearish" seller wants to "short" the XYZ because to them that last downtick signals the start of a potential downtrend in the price of the XYZ. They don't want to miss the entry into this downtrend, so they impulsively lower their offer to $8 (even though they where positioned in the seller queue at an initial offer price of $12). The next in line buyer is quite happy to have their order for XYZ filled at their intended bid price of $8, so the broker settles this transaction and the official last price of the XYZ is now at $8.
The next load of buyers don't share the same view as the previous seller who believes that the XYZ will trend down. These buyers are "bullish' on the XYZ and many of them are in a bargain hunting mood. The next buyer in line is willing to bid $7 for the XYZ. The buyer that was behind them jumps ahead in the queue by placing an order at a bid price of $9. An even more bullish buyer leapfrogs both of these buyers by bidding $11 and ends up at the very front of the buyer's queue. The seller that held off selling at lower prices is getting nervous and doesn't want to miss this selling opportunity in case the XYZ does trend down. They jump at the chance to lower their offer price and sell at $11. The broker settles, and the last price of XYZ is now at $11 on the chart, up from $8.
Next in the buyer's line is that trader who was willing to bid $9 for the XYZ. Nothing happens because there are no sellers offering XYZ at $9. So the buyer ups their price to $11. Still nothing happens, because the seller at $11 had been "bought out" by the leapfrog buyer. The next seller in line has been watching the price action and has decided that they won't sell for less than $14 - they are confident that the current bullish sentiment of the buyers will eventually drive the XYZ up to their offer price. So the $11 buyer ups their bid price one more pip to $12...
At first glance there seems to be no physical sellers in the queue at an offer price of $12. However, there is a sell order registered at $12 - it's the stoploss order that the bearish short seller placed in case they'd made the wrong call. Instantly the buyer's bid of $12 is automatically executed by the broker against the $12 stoploss order of our short-seller. The last settled price of XYZ is now at $12.
This is a slow-motion example of why the XYZ rate ticked from $10 to $9, down to $8, spiked up to $11, and ticked up to $12.
The current price of an exchange rate is always the "last price" that a transaction was settled at.
In real life this is way more complicated and dynamic than our tiny example - it happens lightning fast on a massive global scale via high speed computerized order executions and super fast settlements. Your own trading decisions can benefit from the insight that even something as massively complex as the interbank Forex market is driven by human beings - like you.
Only the very biggest of the Forex players have access to the level of buyer/seller data outlined above (called "market depth"). Market Depth is a great place to watch the economic forces of demand and supply being shaped by fear and greed. Watch out for when these big market players decide to use this "inside information" about market depth in combination with their billion dollar bank wallets. They can place a continuous string of large bid/offer orders to nudge an exchange rate in the directions that suit them or their clients best (for maximum profits). This situation presents both dangers and opportunities for you to profit from their actions.

All we are trying to do as traders is figure out which side of the currency is stronger
The supply side
or
The demand side

The reasons why one side is stronger than the other side change from time to time and/or involve several factors. Like kids on a seesaw, the conditions that favor one side vs. the other side accumulate for one side, then later for another, then back again.

Either move with the crowd or be moved by the crowd.