What exactly sets an exchange rate in Spain is its price in terms of another currency. Most major currencies such as the pound, dollar, euro and yen for instance are known as freely floating. This simply refers to the fact that their exchange rate is determined by market forces, by the levels of supply and also the demand on the international markets.
There are numerous factors which affect this such as interest rates. A higher interest rate will provide a higher return on gilts, bonds and other Government securities and will, therefore, tend to attract financial capital from overseas. Sterling must be purchased in order to buy these assets so that if interest rates in the United Kingdom go up, or more importantly, are expected to go up, the pound will tend to get stronger against other currencies, and vice versa.
Economic health also affects currency rates as Institutions tend to move investments out of weakening economies and into those that are perceived to becoming stronger. Therefore an economy which shows positive growth, inflation and debt burden tends to see a much greater demand for its currency which in turn will see its exchange rate strengthen. The pound has generally seen itself rated strongly against both the dollar and the euro in recent years, as its economy has done relatively well.
Foreign trade is also an important factor as other countries must buy sterling in order to buy UK goods, therefore if there is a high demand for British exports relative to the UK’s demand for foreign imports, the pound will tend to get stronger. Large trade deficits as the UK has experienced in recent years will tend to depress a currency. However, it is a circular relationship as the exchange rate will also affect levels of imports and exports. If the pound is strong, UK exports become less attractive, and foreign imports more so.
Another factor which can influence currency fluctuations is official interventions where governments or central banks could intervene to strengthen a currency for political or economic reasons by buying it on the international markets, or by raising interest rates. The John Major government in 1992 for instance controversially raised interest rates by 5 percentage points and spent billions in a doomed attempt to keep sterling in the European exchange rate mechanism.
Finally, shocks and speculation can play a part in currency rates as markets do not like unexpected news and because currency markets are very ‘liquid’, shortages of a currency are very rare, and exchange rates are prone to move quickly in response to surprises. Currencies are also traded as speculative investments in their own right, and professional brokers trade them according to how they think the market will move although these trades in themselves will, of course, affect exchange rates.
Many ex pats may be familiar with buying and selling currencies due to the necessity to move between currencies. The currency exchange is usually done via a bank or a professional currency exchange company. The banks and the exchange companies make a profit by purchasing low and selling higher or vice versa. These days most companies no longer charge a commission fee, as there profit is in the currency trading.
It is possible for the independent investor to buy and sell currencies electronically, without the need to actually hold the physical currency. This type of exchange can be done via a currency trading firm which allows you to buy and sell different currencies.
An example of this would be if you thought the strength of the Euro was going to increase against the British Pound, you could buy EUR/GBP and sell EUR/GBP at a later date. This later date could be a couple of seconds, days, weeks or even years. The time scale and amount you buy or sell the currency is up to the trader, and dependent on how much liquid cash is in your trading account. This liquid cash can also be leveraged so that a £1,000 trading account could be leveraged to provide the buying power of £100,000. This means any gains are amplified, however, it also means that any losses will of course be amplified as well.
Currency trading can also be used as a hedge against currency exchange risk. If you have a business or earnings in one country, and live in another country, then you can hedge the exchange rate to ensure that you are not negatively impacted by currency fluctuations. To be profitable in trading currencies, knowledge of the currency markets is a must.