A foreign exchange rate is defined as the price of a currency in terms of the foreign currencies,

that is, it is the rate which the local currencies is traded in terms of a basket of other currencies.
Shapiro (2014) defines an exchange rate as simply, the price of one nations currency in terms of
another currency, often termed the reference currency. The main reference currency is the United
States Dollar. An exchange rate can be quoted on a directed or indirect basis and can be a spot or
a forward or even future exchange rate depending on the nature of the transaction. The factors that
determine the exchange rates are explained below.

Relative price levels. When the price of domestic goods and services rise, holding other things
constant, the demand for domestic goods falls as the local exports become less competitive, and
the local currency tends to depreciate so that local commodities can be more competitive. On the
other hand if foreign products increase in price relative to local commodities, the domestic
currency tends to appreciate in value because the local exports will become more competitive on
the international markets. In a nutshell, in the long run, a rise in a countrys price level relative to
the foreign price level causes its currency to depreciate and a fall in the countrys relative price
level causes its currency to appreciate.

Tariffs and quotas. Barriers to free trade such as tariffs known as import duties, which are taxes
levied on imported goods, and quotas, which are quantitative restrictions of foreign goods that can
be imported can affect the exchange rate. The trade restrictions increase the demand of domestic
as they tend to make imports more expensive and the domestic currency tends to appreciate in
value because it makes local products more competitive. In other words, increasing trade barriers
causes a currency to appreciate in the long run.

Preferences for domestic versus foreign goods. Increased demand for a countrys exports causes
its currency to appreciate in the long run and on the other hand, increased demand for imports
causes the domestic currency to depreciate. If the South African market develop an appetite for
Zimbabwean products, the increased demand for local goods which are exports tends to appreciate
the local currency because the local commodities will continue to sell even at higher value.

Similarly if preferences shift towards South African products, the increased demand for imports
will result in the depreciation of the local currency.

Differential inflation rates. Changes in relative inflation rates can affect international trade
activity, which influences the demand for and supply of currencies and therefore influences
exchange rates. A higher rate of inflation relative to the inflation rates of foreign countries causes
the currency to depreciate as its exports become less competitive as compared to cheaper imports.
In Zimbabwe the dollar depreciated to rock bottom against the rand and the US Dollar due to long
period of hyperinflation which led to the collapse of the purchasing power of the Zimbabwean
dollar. The Purchasing Power Parity Theory explains the relationship between inflation rates and
exchange rates. It suggest that the exchange rate will on average, change by a percentage that
reflects the inflation differential between two countries.

Productivity. If one country becomes more productive than other countries, business in that
country can lower the prices of domestic goods relative to foreign goods and still earn a profit. As
a result, the demand for domestic goods rises, and the domestic currency tends to appreciate. If
however, its productivity lags behind that of other countries, its goods become relatively more
expensive, and the currency tends to depreciate. In the long run, as long as a country becomes
more productive relative to other countries, its currency appreciates.

Differential interest rates. Interest rate movements affect exchange rates by influencing the
capital flows between countries. An increase in the domestic interest rates relative to foreign
interest rates may attract foreign investors, especially if the higher interest rates do not reflect an
increase in inflationary expectations. Increased demand for domestic interest bearing securities
will result in increased demand for the domestic currency thereby causing its appreciation. If
interest rates in the domestic economy, decline, it results in an upward pressure on the foreign
currency and a downward pressure on the value of the domestic currency. Differences in interest
rates among countries and movements would also impact on the exchange rate through the flow

of hot money. A country with higher interest rates will attract short term funds from those with
lower interest rates.
According to the Interest Rate Parity Theory, the interest rates in different countries should be
equal so as to avoid arbitrage. A country with low interest rate will experience depreciation in the
value of its currency against other countries with higher interest rates.

Relative Economic Growth Rates. Similarly, a nation with strong economic growth will attract
investment capital seeking to acquire domestic assets. The demand for domestic assets, in turn,
results in an increased demand for the domestic currency and a stronger currency, other things
being equal. Empirical evidence supports the hypothesis that economic growth should lead to a
stronger currency. Conversely, nations with poor growth prospects will see an exodus of capital
and weaker currencies.

Political and Economic Risk. Other factors that can influence exchange rates include political
and economic risks. Investors prefer to hold lesser amounts of riskier assets; thus, low risk
currencies that is, those associated with more politically and economically stable nations, are more
highly valued than high-risk currencies.

Central bank intervention. A countrys government can intervene in the foreign exchange market
to affect a currencys value. Direct intervention occurs when a countrys central bank sells or buys
some of its currency reserves to defend the value of its currency. Central bank intervention may
significantly affect the foreign exchange markets in two ways. It may slow down the momentum
of adverse exchange rate movements and the foreign exchange market participants may reassess
their foreign exchange strategies if they believe the central bank will continue to intervene. In
Zimbabwe the Central Bank maintained a fixed exchange rate against the major currencies but it
could not yield the desired results as most of the foreign currency found its way towards the black
market which had more market determined rates of exchange.

Speculation. This refers to the short-term commitment of funds with the purpose of making a gain
out of future exchange rates movements. Foreign exchange markets have speculators who buy and
sell currencies against their expectations and they also affect the determination of exchange rates.
In Zimbabwe in 2003 there was the triangular arbitrage by speculators who used to exchange
Zimbabwe dollars to make speculative gains in exchange rates mispricing of the Botswana Pula
and South African Rand.

References

1. Shapiro A.C (2014) Multinational Financial Management 10th Edition. John Wiley and
Sons
2. Madura J. (2008) International Financial Management 9th Edition. Florida Atlantic
University
3. Chisholm A.M (2009). Introduction to International Capital Markets 2nd Edition London:
John Wiley and Sons.
4. Fabozzi F.J (2007) Fixed Income Analysis 2nd Edition John Wiley and Sons.
5. Interfin Financial Holdings (2011) Unpacking Dollarization in Zimbabwe. Harare
Zimbabwe.
6. Madzirerusa K (2012) Money and Capital Markets. ZOU Module for Master of Business
Administration. ZOU Press, Harare Zimbabwe