A currency has no cash flow to value. Its price reflects interest rates, inflation, trade and capital flows and sentiment, and forward prices are set mechanically by interest rate differences.
11 min read · Level 5
Currencies are the purest example of a market with no fundamental anchor that a trader can calculate in real time, and I think that is why they attract so much confident storytelling. An explanation for yesterday's move is always available. A reliable method for tomorrow's is much rarer, and a trader should be suspicious of anyone who sells the second while offering only the first.
Shares can be valued from profits and bonds from their payments. A currency has neither, so there is no intrinsic value to calculate. Its exchange rate is set by supply and demand in a mostly interbank market, and the main forces are:
Driver Typical effect Interest rates higher relative rates can attract capital and support a currency Inflation higher relative inflation erodes a currency over time Trade and capital flows demand for a country's goods and assets Risk sentiment some currencies strengthen in stress, others weaken Central bank action intervention or policy surprises
Forward exchange rates - prices agreed today for exchange later - are not forecasts. They follow from interest rate differences, a relationship called interest rate parity:
Forward = Spot x (1 + quote rate) / (1 + base rate)
With EUR/USD spot at 1.1000, a one-year dollar rate of 5% and a euro rate of 3%:
Forward = 1.1000 x 1.05 / 1.03 = 1.1214
The forward is higher because holding dollars earns more interest, which the forward price offsets.
Retail traders see a bid and an ask. The spread between them is the broker's and market's charge for immediate trading, and it widens when markets are thin or volatile.
Because without an anchor like earnings, currency prices can stay away from any estimate of fair value for years. Long-run theories, such as purchasing power parity, describe tendencies over very long periods, not what the price will do next month.
It also corrects a common misunderstanding: a forward rate above spot does not mean the market expects the currency to rise. It reflects interest rates.
And it explains why spreads matter more in forex than they seem to. Small moves plus leverage mean even a couple of pips of spread is a meaningful share of a typical short-term trade.
This is educational information, not investment, securities or financial advice. Rules differ by country and change — get advice from a qualified professional in your jurisdiction before acting.
Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
Sources: U.S. CFTC - Commodity Futures Trading Commission; U.S. SEC - Investor.gov; IOSCO - global securities regulators
Reading a quote. A broker shows EUR/USD bid 1.0998 and ask 1.1000.
Spread 0.0002 = 2 pips Cost per standard lot 2 x 10 dollars = 20 dollars
A trader who opens and immediately closes one standard lot loses 20 dollars at unchanged prices. A short-term strategy aiming for a 10-pip gain spends 2 of those 10 pips, or 20%, on the spread alone.
A spread in stress. During a sudden market event the same broker's spread might widen to 10 or 20 pips. A stop-loss triggered at that moment fills at a much worse price than the trader planned.
Treating a forward rate or a long-run fair-value model as a prediction. Forward rates encode interest differences; fair-value estimates can be wrong for years.
Recognise that forward rates come from interest rate differences, not from expectations about the future spot rate.
Divide the spread in pips by the pips you hope to gain. If it is a large fraction, the strategy starts far behind.
Identify whether rates, inflation, flows or risk sentiment has driven the pair recently, and accept that the dominant driver changes.
When interpreting currency quotes, forward prices or claims that a currency is over- or undervalued.
Do not use a single driver, such as an interest rate announcement, as a reliable trading signal. Markets often price expected changes in advance.
On 15 January 2015 the Swiss National Bank unexpectedly removed its minimum exchange rate against the euro. The Swiss franc strengthened dramatically within minutes, spreads widened sharply and many stop-loss orders filled far from their set prices. Several retail brokers reported large client losses, and some became insolvent, as widely reported at the time.
A price floor or peg held by a central bank can disappear without warning, and leveraged positions built on it can be destroyed in minutes.
Create a free account to read the rest and apply it to your own investing.