Currency value factors

The value of a currency subject to a floating rate regime (ie. not fixed or pegged) is ultimately determined by supply and demand (see Figure 1). The relative balance between supply of and demand for a currency can be driven by a variety of factors, but they can be broadly divided into two categories:
• Transaction demand - the transaction demand for a country's currency is largely determined by its levels of economic activity, gross domestic product, and employment. For example, high levels of unemployment will typically dampen consumption. Transaction demand changes are relatively easy for central banks to accommodate by adjusting the available money supply.
• Speculative demand - the speculative demand for a currency is considerably harder for a central bank to influence but it will attempt to do this by adjusting interest rates. A sufficiently high interest rate may be sufficient to encourage speculative purchase of a currency. (See 'Carry Trades' below.) However, very large currency speculators have historically been able to overcome this strategy by selling in exceptional size, as was the case with the UK's exit from the ERM in 1992.

An important element within transaction demand is a country's trade balance. This is the net difference between the value of merchandise being exported and imported into the country. For example, the net difference between the Japanese demand for US dollars to buy American merchandise, and the supply of yen affected by US purchases of Japanese merchandise, is the merchandise trade balance between the two countries.
A similar situation applies in the long term as regards the currency flows required to pay for non-tangible merchandise such as securities. However, in the near term, capital flows are greatly influenced by yield differentials, which represent the difference in interest rates between countries. Logically, a higher yield on Japanese securities (compared to American securities) would make Japanese securities more attractive. Furthermore, an increase in Japanese yields would raise the flow of US dollars into Japanese securities, and decrease the outflow of yen to American securities. This increased flow of funds into Japan would lower the value of the US dollar and increase the value of the yen, so USDJPY would fall.
A further significant factor in a country's currency strength is its level of price inflation. Understandably, consumers try to avoid the eroding effect inflation has on their purchasing power, so goods from countries with low inflation become more attractive than the goods from countries with higher inflation. At the same time, the currency from the lower inflation country rises in value, while the currency from the higher inflation country falls in value. Both relative inflation and the purchasing power of the currencies directly affect their exchange rates.
For example, if the UK was experiencing lower inflation than Australia, GBPAUD would rise to reflect growing price levels in Australia relative to the UK. This is based on the concept of Purchasing Power Parity, which states that in the long run a currency exchange rate adjusts to reflect the difference in price levels between countries.
Carry Trades
The role interest rates play as a currency value factor was mentioned earlier. A popular speculative trade that takes into account the relative interest rates of two countries when determining which currency to buy and which to sell is the 'carry trade'. In a carry trade, an investor borrows in a low interest rate currency, such as the US dollar, and also takes a long position in a higher interest rate currency, such as the Australian dollar, in the assumption that the exchange rate will not change so as to offset the interest rate differential.
If the low interest rate currency depreciates and the interest rate differential persists, such a trade will be profitable. In recent years, carry trades have been very popular in AUDUSD, and more recently carry trades involving ISK (Icelandic kronur).