The fluctuations in FX rates in a floating exchange rate regime are explained by the following theories:

1. International parity conditions
2. Balance of payments model 
3. Asset market model

None of the models that has been developed so far have achieved success to explain FX rates levels and volatility in the longer time frames. The above models make us understand that the exchange rates are affected by many macroeconomic factors and in the end currency prices are a result of dual forces of demand and supply.

For any given currency Supply and demand, and thus its value, are not influenced by any single element but rather than that they are influenced by several factors. These elements are generally divided into three categories:

1. economic factors,
2. political conditions
3. market psychology

Economic factors

The economic factors include:

• economic policy, that are disseminated by government agencies and central banks,
• economic conditions, that are generally elaborated through economic reports,
• and other economic indicators.

Economic Policy:

Government fiscal policy (budget/spending practices) and monetary policy constitutes economic policy. Monetary policy is considered as the means by which a government’s central bank influences the supply and "cost" of money, which is reflected by the level of interest rates.

Economic Conditions:

Economic conditions include:

The market usually show negative reaction to the widening government budget deficits, and react positively to narrowing budget deficits. The reflection of this impact is shown in the value of a country’s currency.

Balance of trade levels and trends

The demand for goods and services is illustrated by the trade flow between countries, which in turn indicates the demand for a country’s currency to conduct trade. The competitiveness of a nation’s economy is reflected by the surpluses and deficits in trade of goods and services. 

Inflation levels and trends

Typically, if there is a high level of inflation in the country or if it is perceived that inflation levels are rising, a currency will lose value. This happens due to the reason that inflation erodes purchasing power, thus demand, for that particular currency.

Economic growth and health

The details of the levels of a country’s economic growth is given by the reports such as GDP, employment levels, retail sales, capacity utilization and others. Generally, the more healthy and robust a country’s economy, the better will be the performance of its currency, and the more demand will be gained by it.

Productivity of an economy

There is a positive influence of increasing productivity in an economy on the value of its currency. We can see more prominent effects if the increase is in the traded sector.

Political Conditions

There could be a profound effect of internal, regional, and international political conditions and events on currency markets.

All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political instability can produce negative impacts on a nation’s economy. For instance, the country currency can be negatively effected by the destabilization of coalition governments in India, Pakistan and Thailand. Similarly, in a country that is experiencing financial difficulties, the rise of a political faction that is believed to be fiscally responsible can have the opposite effect.

Market Psychology

The foreign exchange market is influenced by Market psychology and trader perceptions in a variety of ways:

Flights to Quality

Unsettling international events can become a reason which leads to a "flight to quality," with investors looking for a "safe haven." Then there will be a greater demand, thus a higher price, for currencies that are believed to be as stronger over their relatively weaker counterparts. The Swiss franc has acted as a traditional safe haven during times of political or economic uncertainty.

Long-term Trends

Currency markets usually move in visible long-term trends. Although there is no annual growing season for currencies like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may have risen by the economic or political trends.

"Buy the rumor, sell the fact"

We can apply this market truism to many currency situations. It is the tendency for the price of a currency to show the impact of a particular action before that it has taken place and, when the expected event comes to pass, the reaction is in exactly the opposite direction. This condition might also be known as a market being "oversold" or "overbought". 

Economic numbers

Economic policy can certainly be reflected by the economic numbers, some reports and numbers take on a talisman-like effect: the number itself becomes significant to market psychology and it might show an immediate impact on short-term market moves. In the most recent years, for example, money supply, employment, trade balance figures and inflation numbers have all impacted severely on market moves.

Technical trading considerations

 

As in other markets,  the accumulated price movements in a currency pair such as apparent patterns can be formed by EUR/USD, that traders may opt to use. Price charts are studied by many traders in order to identify such patterns.

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