Foreign exchange rates change due to the laws of supply and demand. When more people want a particular currency, the value of that currency will go up in relation to another currency. When there is an overabundance of that currency, people will demand less of it and the value will go down.

International commercial flows affect the demand for a currency. When U.S. airlines want to buy European airplanes, they must convert their US dollars to Euros. They must buy EUR/USD. International capital flows also affect the value of a currency. In order to complete an acquisition of a Canadian software company, a UK technology company needs to convert its GBP into CAD.  The UK technology company will sell GBP/CAD.

Interest rates affect the value of a currency. As the interest rate for a particular currency increases, the demand for that currency increases. Money managers want to buy that currency and fixed income products denominated in that currency, in order to earn the yield A U.K. hedge fund has to convert its Sterling into Australian dollars in order to buy Kangaroo Bonds because the Aussie bonds will yield more interest than Sterling Bonds. The value of GBP/AUD will go lower because the hedge fund is selling GBP and buying AUD.

 

The political situation of a nation will affect the demand for its currency. A stable and open government will generally foster greater economic prosperity and better business conditions. This will increase the demand for the nation’s assets such as its manufactured products, its innovative companies, and its currency. Unstable governments will engender fear from the market. Businesses will shy away from selling products in politically unstable countries. Investment funds will not risk their money in tumultuous and uncertain environments. Political instability will also bring about interest rate  instability as the rates market will not have any certainty over the direction of the economy in the next year.