- “Which currency will go up?”
- “Which currency should I buy now?”
- “I am currently holding some Australian Dollars. Should I sell it now or hold it?”
This list is by all means not exhaustive but these were real questions I got from different people in the past.
In this article, I am going back to the basics of Forex trading and address the question how the value of a currency is determined. If you are new to Forex, hopefully you will find the discussion below useful. If you are already an experienced Forex trader, I hope you will still benefit from my sharing.
Currency is always traded in pairs
Believe it or not, there is no answer to the question “which currency will go up?” The reason is that currency is always traded in pairs. I am sure most of you had gone for overseas vacations before. Recall your last overseas trip. Did you use your home currency to exchange for the currency of the country you were visiting based on the quote from your money changer? You did a Forex trade. In essence, you bought the currency of the country you were visiting and sold your home currency.
As you can see, a Forex quote is always derived from two currencies. Let’s use Euro (“EUR“) and the US Dollars (“USD“) as an example. Suppose EUR/USD is now 1.2500. This means that for every EUR100, we can exchange for US$125. Conversely, for every US$100, we can exchange for EUR80.
A currency pair is a fraction
A currency pair can be seen as a fraction too. This means that we can use math to explain the movement of a currency pair. I have found this method very useful whenever I need to explain this concept to novice Forex traders.
Suppose C = A/B. The value of C will go up if one of the following occurs:
- when A goes up but B remains constant;
- when A remains constant but B goes down; or
- when A goes up and B goes down at the same time.
Now, if A is EUR and B is USD, the value of EUR/USD will go up if one of the following occurs:
- when EUR is strengthening but USD remains constant;
- when EUR remains constant but USD is weakening; or
- when EUR is strengthening and USD is weakening at the same time.
Now I hope you will know how to ask your next Forex question properly. Instead of asking the question “which currency will go up?“, the proper question to ask is “which currency pair will go up?” At all times, we are evaluating the relative strength or weakness of one currency against the other currency.
Using the law of demand and supply to explain the relative strength or weakness of one currency against the other currency
The law of demand and supply in Economics is useful to explain the relative strength or weakness of one currency against the other currency. Let’s consider the following scenarios. In both scenarios, we will assume the money supply in Country B remains stable.
Country A decides to raise the interest rate to control the rising inflation rate. Generally speaking, when interest rate increases, there will be an increase in the demand for the currency. In this case, if the currency pair in question is expressed as A/B, we will expect the value of this pair to go up.
Country A decides to increase the money supply in order to stimulate the economy and hopefully this will translate into an increase in business and consumer spending. In this case, if the currency pair in question is expressed as A/B, we will expect the value of this pair to go down.
Please keep in mind that the above discussion has been simplified mainly for the benefit of the novice Forex traders. The world operates in a much more complex fashion which means that there are many factors that need to be incorporated into this discussion. This deserves the space of another article in future.