Now that you have been exposed to the basics of charting, we are now going to shift gears a little bit and delve further into the fundamental analysis aspect of forex by looking at some of the economic theories that affect currency rates. When it comes to forex, a currency's relative worth depends on its parity with another currency. A parity condition is a relationship based around concepts (such as inflation and interest rates) that predict the price at which two currencies should be exchanged.
Other theories are based on economic factors such as trade, capital flows and the way a country runs its operations. However, be aware that while economic theories help to illustrate the basic fundamentals of currencies and how they are impacted by economic factors, they are based on assumptions and perfect situations. There are so many complexities involved when all of many of these factors are combined. This increases the difficulty in any one of them being 100% accurate in predicting currency fluctuations. The main value will likely vary based on the market environment, but it is still important to know the fundamental basis behind each of the theories.
Purchasing Power Parity
The basis behind this theory is that the cost of a good should be relatively the same around the world (assuming that supply and demand levels are universal). More specifically, the Purchasing Power Parity (PPP) contends that price levels between two countries should be equivalent to one another after an exchange-rate adjustment. In the example that we will be talking about, inflation will determine the currency's exchange-rate adjustment.
The relative version of PPP is as follows:
Where 'e' represents the rate of change in the exchange rate and 'π1' and 'π2'represent the rates of inflation for country 1 and country 2, respectively.
For example, if country XYZ's inflation rate is 10% and country ABC's inflation rate is 5%, then ABC's currency should appreciate 4.76% against that of XYZ.
Therefore, if you were trading the ABC/XYZ currency pair and your analysis of the PPP indicates ABC will appreciate shortly, you should sell XYZ to buy ABC.
Interest Rate Parity
Interest Rate Parity (IRP) contends that two assets in two different countries should have similar interest rates, as long as the country's risk is the same. Keep in mind that in this case, interest rates represent the amount of return generated.
So iIn other words, buying one investment asset in a country should yield the same return as the exact same asset in another country; otherwise, exchange rates would have to adjust to make up for the difference.
The formula for determining IRP can be found by:
Where 'F' represents the forward exchange rate; 'S' represents the spot exchange rate; 'i1' represents the interest rate in country 1; and 'i2' represents the interest rate in country 2.
For example, the interest rate for ABC and XYZ was respectively 10% and 5%, and the spot rate was 10 ABC dollars for each 1 XYZ dollar. The forward exchange rate should be 10.5 ABC dollars for each XYZ dollar.
Connected to this theory is the real interest rate differential model, which suggests that countries with higher real interest rates will see their currencies appreciate against countries with lower interest rates. Global investors tend to allocate their capital to countries with higher real rates in order to earn higher returns, which in turn bids up the price of the higher real rate currency.
International Fisher Effect
The International Fisher Effect (IFE) theory suggests that the exchange rate between two countries should change by an amount similar to the difference between their nominal interest rates. If the nominal rate in one country is lower than another, the currency of the country with the lower nominal rate should appreciate against the higher rate country by the same amount.
The formula for IFE is as follows:
Where 'e' represents the rate of change in the exchange rate and 'i1' and 'i2'represent the rates of inflation for country 1 and country 2, respectively.
Balance of Payments Theory
The balance of payments is comprised of two segments - a country's current account and capital account - which measure the net inflows and outflows of goods and capital, respectively. A country that is running a large current account surplus or deficit is indicating that its exchange rate is out of equilibrium. In order to bring the current account back into equilibrium, the exchange rate will be adjusted over time. A large current account deficit (more imports than exports) will result in the domestic currency depreciating. On the other hand, a surplus is likely going to cause currency appreciation.
The balance of payments identity is found by:
BCA represents the current account balance
BKA represents the capital account balance
BRA represents the reserves account balance
The monetary model focuses on the effects of a country's monetary policy in influencing the exchange rate. A country's monetary policy affects the money supply of that country by both the interest rate set by the central bank and the amount of money printed by the Treasury. The basic lesson to understand is that when countries adopt a monetary policy that rapidly grows its monetary supply, inflationary pressure due to the increased amount of money in circulation will lead to currency devaluation. (For more on how monetary policy works, see Formulating Monetary Policy.)
Economic theories may move currencies in the long term, but on a shorter term, day-to-day or week-to-week basis, economic data has a more significant impact. It is often said the biggest companies in the world are actually countries and that their currency is essentially shares in that country. Economic data, such as the latest gross domestic product (GDP) numbers, are often considered to be like a company's latest earnings data. In the same way that financial news and current events can affect a company's stock price, news and information about a country can have a major impact on the direction of that country's currency. Changes in interest rates, inflation, unemployment, consumer confidence, GDP, political stability etc. can all lead to extremely large gains/losses depending on the nature of the announcement and the current state of the country.
The number of economic announcements made each day from around the world can be intimidating, but as one spends more time learning about the forex market it becomes clear which announcements have the greatest influence.
Macroeconomic and Geopolitical Events
The biggest changes in the forex market often come from macroeconomic and geopolitical events such as wars, elections, monetary policy changes and financial crises. These events have the ability to change or reshape the country, including its fundamentals. For example, wars can put a huge economic strain on a country and greatly increase the volatility in a region, which could impact the value of its currency. It is important to keep up to date on these macroeconomic and geopolitical events.
There is so much data that is released in the forex market that it can be very difficult for the average individual to know which data to follow. Despite this, it is important to know what news releases will affect the currencies you trade. (For more insight, check out Trading On News Releases and Economic Indicators To Know.)
Now that you know a little more about what drives the market, we will look next at the two main trading strategies used by traders in the forex market – fundamental and technical analysis.
TradingThe exchange rate is one of the most important determinants of a country's relative level of economic health and can impact your returns.
TradingIn general, higher interest rates in one country tend to increase the value of its currency.
InvestingA government using a fixed exchange rate has linked the value of its currency to the value of another country’s currency, or the price of gold.
InsightsThe Fisher models have the ability to illustrate the expected relationship between interest rates, inflation and exchange rates.
InsightsPurchasing Power Parity (PPP) is an economic theory that compares different countries' currencies through a market "basket of goods" approach.
TradingLearn the basics of forward exchange rates and hedging strategies to understand interest rate parity.
InvestingCentral banks and financial institutions hold large amounts of foreign money as their reserve currency.
TradingCurrency fluctuations often defy logic. Learn the trends and factors that result in these movements.