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Forex rates are the rates at which currencies on the foreign exchange market are traded. Are you interested in what is behind them? The rate fluctuations are explained by means of a number of theories. These include international parity conditions, the balance of payment model, and the asset market model.

First, let us mention that these theories apply only in the conditions of a floating exchange rate. If the rates are fixed, they are set by the government authorities.

International conditions include various aspects related to buying power and interest rates. Assumptions about conditions are based on concepts such as the free flow of capital, goods, and services. Thereby, these can be challenged because concepts are rarely applicable in reality. The balance of payment focuses on exchangeable goods and services and neglects to take into consideration the role of global capital flow. This model could not explain why, in the conditions of a skyrocketing current
account deficit, the US dollar appreciated throughout the 1980s. Finally, the asset market model defines currencies as significant assets, the prices of which are affected mostly by human desire to own existing quantities of assets. This model is based on the idea that people believe in the rising value of assets in the future. Thus, the exchange rate between two currencies is the amount that strikes a balance between the supply and demand of assets, the value of which is expressed in these currencies.

Apart from these three theoretical models, there are other factors that affect Forex rate levels, especially in the long term. Lack of knowledge of these is what stops us from making accurate predictions. Algorithms are developed to predict the rates in the short term, and many institutions and professionals consistently profit from these. As for supply and demand, it is well-known that these factors are perpetually changing and thus, currency rates shift in relation to one another. This is why, Forex is the biggest melting pot of all. It is the only market that incorporates so much of what is going on in the world at any point in time.

With regard to the other factors, they typically fall into three basic groups: economic, political and psychological. Economic factors include economic conditions and policies, revealed through various reports and publicized by the central banks and government agencies.

Political stability or instability can and does affect all currency exchange rates. Upheaval can have an adverse effect on the economy of any country around the world. This is why, it is sometimes hard to separate political from economic issues.

Finally, the notion of market psychology incorporates mass tendencies, such as “fleeing” to safe havens like gold and the Swiss franc in times of crisis. Factors which contribute to the investing sentiment or mentality include fear, greed, circumstances, and expectations. The conventional financial theory focuses on those situations in which market players act in a rational and logical manner. It does not take into account the impact of emotions on the market dynamic, which may result in unexpected outcomes at times. Emotions and mass tendencies cannot be predicted by just focusing on the fundamentals.