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Fixed Income

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How is a currency valued?

The floating exchange rate system is a confluence of various demand and supply factors prevalent in an economy such as:

Current account balance- The trade balance is the difference between the value of exports and imports. If India is exporting more than it is importing, it would have a positive trade balance with USA, leading to a higher demand for the home currency. As a result, the demand will translate into appreciation of the currency and vice versa.

Inflation rate- Theoretically, the rate of change in exchange rate is equal to the difference in inflation rates prevailing in the 2 countries. So, whenever, inflation in one country increases relative to the other country, its currency falls.

Interest rates- The funds will flow to that economy where the interest rates are higher resulting in more demand for that currency.

Speculation- Another important factor is the speculative and arbitrage activities of big players in the market which determines the direction of a currency. In the event of global turmoil, investors flock towards perceived safe haven currencies like the US dollar resulting in a demand for that currency.

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