What factors cause a currency to appreciate?

Forex traders buy or ‘go long' on a currency pair in the hope that the base currency will appreciate relative to the quote currency. To understand currency appreciation, we should briefly look at the intricacies of a currency pair.

A currency pair is made up of a base currency and a quote currency. The base is always worth one, and the quote represents how many of that currency you would need to sell in order to buy one of the base currency.

For example, if the pair was EUR/USD, the euro is the base currency and the US dollar is the quote. If the quote price was 1.25, it means that you would have to spend 1.25 dollars in order to buy one euro.

Example of currency appreciation

A forex trader might take a long position on EUR/USD if it started to cost more dollars to buy one euro. In the above example, if the quote price increased from 1.25 to 1.50, it would be said that the euro has appreciated in value next to the dollar, since it now costs more dollars to buy the same number of euros as before.

What factors cause a currency to appreciate?

There are several factors which can cause a currency to appreciate. Two of the most important are:

Inflation and interest rates

Lower inflation rates typically mean that a currency’s value will appreciate relative to other currencies with higher inflation rates. This is because lower inflation rates cause interest rates to rise. A higher interest rate will attract more foreign investment in a country which in turn increases the demand for its currency. While this often causes the currency to appreciate, it is not always so finely cut.

Investor sentiment

Currencies can also appreciate depending on how ‘safe’ investors view the country's central bank and government.

For example, Switzerland has long been considered a safe haven for investors, which means the currency appreciates in times of economic crisis. This is because of its historic neutrality in wars and tendency towards political stability and relatively free monetary policy; as well as its openness to foreign investment. These policies have made the Swiss franc one of the most heavily-traded currencies in the world.

Investor sentiment heavily influences the supply and demand for a currency on the open market, which are perhaps the largest drivers behind whether a currency appreciates or depreciates. The currencies which are most susceptible to influence by supply and demand are those that operate on a floating exchange rate.