The Forex market is far more active and fast paced than the conventional stock market and a new investor needs to tread with caution here. In order to be a successful trader in the foreign exchange market, you need to know the basics of Forex trading and what factors influence the market. Also required is a substantial amount of research and study to forecast and trade in the foreign currency exchange market. Forex has the power to make or break your financial standing in the market, so make sure that an experienced Forex trader or broker is guiding you. In a highly dynamic market such as Forex, the supply and demand forces prevailing in the market affect the currency rates. At times, the central bank is compelled to intervene in the floating market to control the foreign currency exchange rates. This form of intervention primarily occurs due to pressure from external sources with an aim to stabilize currency rate fluctuations.
In order to know the intervention techniques used, you need to first understand why the bank is forced to intervene. With constant fluctuations, it sometimes becomes difficult to make investment decisions subsequently affecting foreign trade. For instance, if the currency rate is so irregular, an investor may be apprehensive of putting in more money and may hold back his investments for a while. As a result, the government or central back is forced to step in to curb the fluctuating prices and encourage investors to resume their investment activities. Bank intervention is also required to stop or reverse trade deficit of a country, as higher exchange rate will imply cheaper goods and services meaning increase in imports. The central bank thus plays a vital role in stabilizing the economy of a country.
The central bank may adopt either a direct or indirect method of intervention. While the direct approach involves trading currency in an effort to control market movements, the indirect approach is used to make changes in the domestic money supply. Among the two, the direct method is more often used to intervene. There is a sudden drop in currency rates as soon as the bank increases the currency supply. Basically, currency value depreciates when the supply increases and vice versa. Thus, when the bank wants to raise the value of a specific currency, all it has to do is purchase it in bulks to reduce the supply and increase demand. However, direct approach has limited effects, as the Forex market soon stabilizes and continues the previous trend.
The indirect method of intervention is quite similar to the direct approach wherein money supply is altered to control the currency exchange rates. Value of currency increases if the supply is reduced, on the other hand, the value drops rapidly if the currency supply is increased. The indirect approach may take quite some time to have a significant impact of currency rates, as it needs to pass through various market operations before it hits the exchange rate. A major drawback of this method is that the central bank has to change the domestic interest rate to make up for the changing fiscal supply.
One thing you must understand is that intervention in the foreign exchange market is not done too often due to the drastic effects it may have on other domestic aspects. For instance, change in fiscal supply will take a heavy toll on rate of interest and cost of living. With high inflation rates and equally high unemployment rates, the gross domestic product growth will be seriously affected.
Financial experts believe that a "sterilized intervention approach" is required to avoid these long-term effects. This form of intervention is achieved when the bank compensates for its direct intervention by making a simultaneous change in the domestic bond market as well to control currency rate fluctuations.
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