Comparing currency exchange rates requires an appreciation of the immediate and long term effects of interest rates and the balance of trade. In the long run, strong currencies are supported by strong countries with technological and educational advantage. Short term trends are often substantial and last for several quarters. These strengths are a function of interest rate differentials that favors short and intermediate investment in a particular country.
Step 1
Know that the price of a currency is not an absolute value. Currency values are relative. Currency prices are stated as value against a basket of currencies or against a specific currency. Currencies have value in terms of what goods and services they can buy in another currency. Example: If $1 (American) can purchase 100 Japanese yen then the yen has a value of 1 cent. If $1 (American) can buy 2 German marks then each mark is worth fifty cents and one yen should be worth one-fiftieth of a mark.
Step 2
Currency rates are affected by short term influences. The important short term influence is the level of interest rates in a country. High interest rates bring short term monies into a country and create demand for the currency. Interest rates must be higher than interest rates in other countries and compensate investors for the risk of loss from currency depreciation.
Step 3
Longer term influences are of more importance. The relative balance of trade between countries is of most importance. Countries with a strong balance of payment accounts (surpluses) will have lower rates of interest. Countries that are debtor nations will have higher interest rates as they cover their shortfalls by borrowing. These are long term, macroeconomic trends that do not change quickly.
Step 4
Currency traders use long and short trends to profit from and predict relative values among all currencies. They trade to arbitrage small differences in values but also take on speculation risk by trading the long term factors that move interest rates. Traders use fundamental analysis to understand the causes of change and technical analysis to time their entry and exit strategies.