Why do Exchange rates fluctuate?

Fundamentals of currency exchange

Currency exchange rates are a measure of the supply and demand for currencies. The two main factors that affect the supply and demand and therefore the exchange rates are interest rates and the strength of the economy. The strength of an economy are measured by many different indicators. GDP, incoming foreign investment, and the balance of trade are the main ones.

During a day, a week a month and a year there is a huge amount of economic data released which affect the money markets. Trying to seive this out to find out the important bits can be very time consuming and difficult to judge which parts will be relevant. Data related to interest rates and international trade is looked at the closest.

Interest Rates

If a country raises its interest rates it will generally strengthen a currency. The reason is because investors start to invest in that country to take advantage of better returns. However higher interest rates also means that investors shift from stocks as they feel that higher borrowing rates will affect balance sheet negatively. Share prices fall and the currency weakens - which effect dominates is not always clear. Interest rate hikes or falls are normally well predicted and so the market factors in the percieved results in advance. Sometimes sentiment or feeling drives a market price - if something doesn't happen as predicted it can have a bigger effect than if something potentially more detremental happened

International Trade

The differnce between imports and exports are the trade balance. When a country imports more than it exports the trade balance will be in deficit which has more downside than upside. If a country imports goods then its currency is sold to pay for the goods driving down its price. Exports have the reverse effect and confidence in the economy follows.