Currency depreciation definition
What is currency depreciation?
Currency depreciation is the decline of a currency’s value relative to another currency. It specifically refers to currencies in a floating exchange rate – a system in which a currency’s value is set by the forex market, based on supply and demand.
The opposite of currency depreciation is currency appreciation, where a currency becomes stronger. Forex traders can take advantage of both appreciation and depreciation, by taking a long or short position depending on their market predictions.
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Examples of currency depreciation
Currencies are always traded in pairs, with the value of one being quoted against the other. The first listed currency – the base currency – is always worth one, while the second currency’s value – the quote currency – is given in relation to this.
For example, if GBP/USD was trading at 1.2700, this means that you would pay $1.27 for £1.00.
If the price of GBP/USD rises from 1.2700 to 1.5000, the dollar would be said to have depreciated in value, and the pound would have appreciated in value – as you would now need more dollars to buy the same number of pounds. This might also be referred to as the pound becoming stronger and the dollar becoming weaker.
Some real-life examples of currency depreciation include the impact of the 2016 Brexit referendum on the value of the British pound – which experienced significant volatility, and at times depreciated rapidly against the dollar. A more dramatic historical example happened in Asia in 1997, when the collapse of the Thai baht affected most Southeast Asian currencies and caused their value to decline sharply.
What causes a currency to depreciate?
Currency depreciation can occur for a variety of reasons. Broadly these include changes in inflation rates, political instability and other economic factors. More specifically, some of the leading causes of currency depreciation are:
- Lower export revenues
- A surge in imports
- Reduced monetary policy interest rates
- Central bank intervention
- Traders and speculators selling currencies on the market
Implications of currency depreciation for traders
Currency depreciation enables forex traders to profit, or causes them to lose, as the currency values fluctuate.
Let’s say a trader has opted to short EUR/USD, believing that the euro is going to depreciate against the dollar. If the price of the euro did fall, the position would incur a profit. But if the euro increased in value instead, they would suffer a loss.
If the trader had taken a long position instead, they would do so in the hope that the euro appreciated against the dollar. If the euro increased in price, they could close their position for a profit. But, if the euro depreciated against the dollar, the trader’s long position would make a loss, as they would have to close their trade at a less favourable exchange rate.
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