In the equities market, fundamental analysis looks to measure a company's true value and to base investments upon this type of calculation. To some extent, the same is done in the retail forex market, where forex fundamental traders evaluate currencies, and their countries, like companies and use economic announcements to gain an idea of the currency's true value.
All of the news reports, economic data and political events that come out about a country are similar to news that comes out about a stock in that it is used by investors to gain an idea of value. This value changes over time due to many factors, including economic growth and financial strength. Fundamental traders look at all of this information to evaluate a country's currency.
Given that there are practically unlimited forex fundamentals trading strategies based on fundamental data, one could write a book on this subject. To give you a better idea of a tangible trading opportunity, let's go over one of the most well-known situations, the forex carry trade. (To read some frequently asked questions about currency trading, see Common Questions About Currency Trading.)
A Breakdown of the Forex Carry Trade
The currency carry trade is a strategy in which a trader sells a currency that is offering lower interest rates and purchases a currency that offers a higher interest rate. In other words, you borrow at a low rate, and then lend at a higher rate. The trader using the strategy captures the difference between the two rates. When highly leveraging the trade, even a small difference between two rates can make the trade highly profitable. Along with capturing the rate difference, investors also will often see the value of the higher currency rise as money flows into the higher-yielding currency, which bids up its value.
Real-life examples of a yen carry trade can be found starting in 1999, when
For example, 10 times leverage would create a return of 30% on a 3% yield. If you have $1,000 in your account and have access to 10 times leverage, you will control $10,000. If you implement the currency carry trade from the example above, you will earn 3% per year. At the end of the year, your $10,000 investment would equal $10,300, or a $300 gain. Because you only invested $1,000 of your own money, your real return would be 30% ($300/$1,000). However this strategy only works if the currency pair's value remains unchanged or appreciates. Therefore, most forex carry traders look not only to earn the interest rate differential, but also capital appreciation. While we've greatly simplified this transaction, the key thing to remember here is that a small difference in interest rates can result in huge gains when leverage is applied. Most currency brokers require a minimum margin to earn interest for carry trades.
However, this transaction is complicated by changes to the exchange rate between the two countries. If the lower-yielding currency appreciates against the higher-yielding currency, the gain earned between the two yields could be eliminated. The major reason that this can happen is that the risks of the higher-yielding currency are too much for investors, so they choose to invest in the lower-yielding, safer currency. Because carry trades are longer term in nature, they are susceptible to a variety of changes over time, such as rising rates in the lower-yielding currency, which attracts more investors and can lead to currency appreciation, diminishing the returns of the carry trade. This makes the future direction of the currency pair just as important as the interest rate differential itself. (To read more about currency pairs, see Using Currency Correlations To Your Advantage, Making Sense Of The Euro/Swiss Franc Relationship and Forces Behind Exchange Rates.)
To clarify this further, imagine that the interest rate in the
However, imagine that there was another crisis in
You should now have an idea of some of the basic economic and fundamental ideas that underlie the forex and impact the movement of currencies. The most important thing that should be taken away from this section is that currencies and countries, like companies, are constantly changing in value based on fundamental factors such as economic growth and interest rates. You should also, based on the economic theories mentioned above, have an idea how certain economic factors impact a country's currency. We will now move on to technical analysis, the other school of analysis that can be used to pick trades in the forex market.
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