At the most basic level, the only thing that will ever affect an exchange rate is the supply and demand for that particular currency at a given point in time. In other words, if a currency have excess demand in the market, this will cause an increase in the value. The opposite happens where the vale of the currency falls when the supply exceeds the demand.
Any speculative transaction in the Forex market is entered into the premise that future exchange rates will move in, in a direction that the position becomes profitable. The below points states the reasons why participants may form a buy or sell bias based on their understanding of the future direction of exchange rates.
- Fundamentals – economic, social and political data, reports and news that market participants can use to determine whether they want to be buyers or sellers of a currency. For example; investors chasing yield would invest in a currency pair with a wide interest rate differential such as the AUD/USD. This is known as the carry trade, where investors will borrow funds from a country with low interest rates and invest them in a country with higher rates.
- Geopolitical outlook for a county or region – assessing the economic and political stability of a country or region, and using this assessment to determine whether an investment opportunity may arise. For example, shorting the USD against the majors during the Iraq war had two benefits; the declining fiscal situation of the US due to the ballooning costs of the war and declining investor confidence.
- Trade flows – importers and exporters buying and selling currencies to make and receive payments for the goods and services they deal in. For example; Japanese companies selling their cars to US will require at some point a conversion from Dollars to Yen. This will increase the demand for the Yen, potentially causing it be higher value.
- Capital flows – speculative and investment flows in and out of a currency to take advantage of higher yields, equity markets, portfolio investments and Mergers and acquisitions.
- Technical analysis – the study of price on charts to make trading decisions. Technical indicators and analysis can give entry and exit signals for trades.
- Market sentiment and climate – this can be anything from the investor's confidence and the scenario of the market to risk, to the liquidity in the market.