One of the most important factors affecting the cost of buying or selling an overseas asset is the exchange rate.
This can make a huge difference to the actual price of the asset, and is therefore one of the key decisions that a buyer or seller of goods and services priced in foreign currency must consider.
By way of an example, at the end of May 2016, a UK buyer of a house in Palma costing €500,000 would have needed around £345,000 to buy it. Now they would require around £424,000, a difference of £79,000, simply due to the fall in value of £ against the € in that period.
Foreign currency exchange rates constantly fluctuate. This fluctuation is a market mechanism for adjusting the relative value of currencies against each other.
Currency values are determined by a mixture of complex factors that, together, make predicting future movements extremely difficult, especially in the short-term.
Whilst the value of a freely floating currency should normally reflect economic fundamentals and investment attractiveness, this is not always the case, and there is no line drawn in the sand when a currency is exactly at fair value. Moreover, market sentiment and future expectations are built into exchange rates, which mean they also carry a weighting of ‘expected future value’.
Foreign exchange rates are also much influenced by supply and demand in the marketplace, liquidity (the volume of buyers and sellers taking part in the market) and speculative market positioning or position unwinding.
Speculators may use other indicators to determine the attractiveness or potential value of one currency against another apart from economic fundamentals such as analysis of historic rate movements as a guide to future direction (technical analysis or charting), for example.
Foreign exchange rates can also be influenced by Central Bank intervention, either when governmental institutions buy or sell currencies directly in the market to influence their value, or by other monetary policy actions such as changing interest rates or quantitative easing. Domestic fiscal policy changes also affect currencies.
As if all this wasn’t enough, currencies are also very susceptible to political news, especially when this involves uncertainty or unexpected policy changes, to natural disasters, wars and conflict and to events in other countries that may have a knock-on effect on other currencies.
In the short term, the foreign exchange market is particularly susceptible to the release of key pieces of economic information and will position itself ahead of the scheduled release of such data based on the most likely outcome. Should the data be outside the area of expectation, this will almost always lead to short-term movements or volatility as currency positions are adjusted to take the implications of unexpected data into account.
With such a bewildering array of factors to consider, it isn’t any wonder that even the most expert foreign exchange analysts get caught out from time to time. A clear example of this was the accumulation of long £ positions ahead of the UK Brexit vote on 23rd June this year. The following morning, upon the unexpected news of a vote to leave the EU, the value of £ dropped significantly and caused a wave of selling which depressed the value of sterling even further. On this occasion, most analysts had got it wrong.
It is therefore extremely difficult for those who only take a passing interest in the currency markets to understand what is going on and how to get best value when they need to exchange currencies. Furthermore, retail buyers and sellers of currencies have to consider the spread they might expect to get (the difference between the buy and sell rate) when executing their transaction. In short, the wider the spread the worse the rate. Spread can vary hugely depending on the size of transaction, market conditions and the bank or broker quoting the rate. Generally speaking, the rate is better for a customer the larger the amount they need to exchange. Hence, at a given moment, an individual buying a small amount of US$ cash at a Bureau de Change will receive a far worse rate than a UK company buying millions of dollars for a US acquisition, for example.
Before making decisions about when to exchange currencies and at what rate, not only do retail clients need to have insightful information about the exchange rate and likely future currency movements but they also need to be able to execute transactions with a bank or broker that will provide the best rate at the time of execution (i.e. at the tightest spread).
This is where currency exchange brokers come in. Their goal is usually to help individuals and small to medium sized businesses navigate their way through the foreign exchange rate markets to find the most cost effective way of switching currencies and making cost free international money transfers. Not only do they provide easy and simple execution services, and tight spreads, they also help their clients to work out the optimum timing and strategies for exchanging currencies bearing in mind the most likely scenarios for future currency movements. They are there to help their clients ‘hedge’ against worse case market scenarios and benefit from positive rate movements.
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This article was written on the 16th of February, 2017.