October 10, 2013

Role of Central Banks in Foreign Exchange Trading

foreign exchange trading

There is no denying the fact that it is important for every forex trader to make sure that he knows the players he will be competing against. This is important because of two reasons. The first is that the trader understands the motivation of his competitors and the second is that he improves his knowledge of the market itself.

One of the most crucial foreign exchange trading players is central banks. Central banks are mainly tasked with managing the value of the currency of their country by their national governments. This is a vast responsibility because it means various things. Here are the main reasons why central banks can choose to intervene in the foreign exchange market.

Maintain or Regain Price Stability

The value of a currency has a direct impact on the way the country’s economy progresses just like economy related movements can impact the currency’s value. When foreign exchange trading has a potent enough impact on the value of a currency, it becomes important for the currency’s price to be stabilised.

This is usually the time when the country’s central bank is required to do everything it can to either maintain or regain the stability of its currency’s value.

Countering Strong Trends

Because the most basic unit of foreign exchange trading is a pair of currencies, it is possible for movement in a few currencies to impact the value of other currencies. Sometimes, big trends are created by changing conditions of a major currency. This, in turn, can affect other currencies. Central banks are often required to counter such strong trends through various actions as well.

Manage National Economic Targets

Finally, as mentioned above, the value of a currency can affect the economy of the country. Therefore, currency rates become a tool in managing the economy of the country and foreign exchange trading gains even more importance. The management of economic targets is also one of the assignments of central banks.

Tangible Actions in the Market

There are various ways that central banks use to achieve their goals in the market. Even so, three are used more commonly. Consider the following.

Direct Buying & Selling in the Market

Direct intervention as another player of foreign exchange trading can be attempted by central banks. When such direct intervention happens, it usually affects the market hugely because cash reserves of central banks are significantly larger than other players. However, as the market can never be cornered, all that the central banks can achieve is to affect the currency’s value to a certain extent.

Manipulating Interest Rates

Borrowing of money internally can also affect forex trading. As the level of borrowing in the country’s economy depends entirely on interest rates, central banks often manipulate them to achieve the desired effects.

Making Statements and Claims

Sometimes, even a hint that the central bank is willing to take action can put cats amongst the foreign exchange trading pigeons. Thus, this concept known as jawboning is also a viable option for central banks.



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