How The Stock Markets Can Affect Exchange Rates

Anyone who has ever taken a trip out of the UK will most likely be familiar with the concept of exchange rates.

Turning money from one currency into another is a common practice at airports, bureaux de change and elsewhere – and it’s essential for ensuring that people have spending power no matter where they go. However, these rates don’t come out of nowhere: from political upheaval to economic data releases, there are all sorts of triggers for an exchange rate alteration.

Another way that the foreign exchange, or forex, markets can be affected is by the stock markets. Buying and selling shares in companies may seem at first glance to be largely unrelated to the rises and falls in exchange rates, but the two are actually quite deeply connected. This article will explain some of the main ways that the stock markets can affect exchange rates.

Level of foreign funds

The main way that the stock market can affect the currency markets is the rate of foreign cash invested in domestic companies. If a stock market is on the rise, then it’s likely that more and more investors from around the world are going to want to invest in it. To do that, though, they need to have access to the local currency. This growth in demand in turn pushes up the value of the currency.

The inverse also works. Say you’re a potential British investor in an American company: you’d need to convert your pounds into dollars in order to make your transaction. If doing this means that you’ve got more purchasing power, then you’re more likely to do it – but if the transaction worsens your position, then you’d be less likely to go ahead as you wouldn’t be able to get the same amount of stock for your money. This can be mitigated, though, by looking for the best exchange rate deals before you make an international money transfer: that way, the costs of the transaction can be cut and the impact of a bad exchange rate can be lowered somewhat.

Certain pairs more affected

That said, this phenomenon isn’t observed everywhere all the time – and there’s plenty of evidence to show that certain stocks have more power over the currency markets than others. An article in the Philippine Daily Inquirer, for example, revealed that it was only specific stocks, such as Petron and Megaworld, that were shown to be connected to currency performance. Other stocks, such as Jollibee and First Gen, were less so.

Perhaps this was down to the company’s operations being too relatively localised to impact global currencies, or more about the global health of the specific industries in which these firms operated. Either way, it’s important for investors to know that the correlation is only noticeable for some stocks – and that the relationship isn’t always a given.

Government-controlled stock markets

So far, this article has analysed only how this relationship works with “free” stock markets and currencies. An interesting example of a currency that doesn’t quite behave in the same way is the Chinese yuan, and that’s because both the Chinese currency and the local stock market are heavily controlled by the government. In China, the stock market isn’t actually an accurate indicator of which stocks are the best. This is because the government imposes a range of measures on it that distort the picture, such as telling large-scale shareholders that they can’t sell in order to prevent slumps.

The laws of supply and demand, then, don’t work here: if the Chinese stock market is up, for example, then there’s not necessarily any rush of demand to change foreign money into yuan for investing because everyone knows the waters are muddied. An added complication is that the currency is split into two, an offshore yuan and an onshore yuan: the latter is managed by the government, which means that any appearance of a connection between it and the performance of the stock market is usually artificial.

Despite stocks and currencies seeming on the face of it like two very different asset classes, they’re actually similar – and the value of the former can have a big impact on the latter in a number of ways. From the way that demand for stocks fuels demand for the local currency to the impact of government influence in certain countries, these two markets are clearly distinctly interlinked – and it’s definitely worth thinking about if you’re going to conduct a major transaction in a currency different to your own.

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