Forex Walkthrough

AAA

Economics - Economic Theories

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:



Where:
BCA
represents the current account balance
BKA represents the capital account balance
BRA represents the reserves account balance

Monetary Model
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 Data
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.
Pivot Points


Related Articles
  1. Forex Fundamentals

    6 Factors That Influence Exchange Rates

    An in depth look at out how a currency's relative value reflects a country's economic health and impacts your investment returns.
  2. Forex

    Main Factors That Influence Exchange Rates

    The exchange rate is one of the most important determinants of a country's relative level of economic health, and can impact your returns.
  3. Economics

    Macroeconomics: Currency

    By Stephen Simpson For citizens of different countries to conduct trade, they have to buy and sell each other's currencies. The price of a nation's currency, expressed as an amount of a second ...
  4. Forex Education

    Interest Rate and Currency Value And Exchange Rate

    In general, higher interest rates in one country tend to increase the value of its currency.
  5. Investing Basics

    Explaining Fixed Exchange Rates

    A 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.
  6. Forex Education

    Forex Tutorial: Fundamental Analysis & Fundamentals Trading Strategies

    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 ...
  7. Forex Education

    Economic Factors That Affect The Forex Market

    Knowing the factors and indicators to watch will help you keep pace in the competitive and fast-moving world of forex.
  8. Economics

    The International Fisher Effect: An Introduction

    The Fisher models have the ability to illustrate the expected relationship between interest rates, inflation and exchange rates.
  9. Forex Fundamentals

    Understanding the Floating Exchange Rate

    Floating exchange rate is the exchange rate between two currencies at any given time.
  10. Forex Education

    8 Basic Forex Market Concepts

    We go over some of the things you need to understand before you can trade currencies.
RELATED TERMS
  1. Uncovered Interest Rate Parity ...

    A parity condition stating that the difference in interest rates ...
  2. Real Effective Exchange Rate - ...

    The weighted average of a country's currency relative to an index ...
  3. Purchasing Power Parity - PPP

    An economic theory that estimates the amount of adjustment needed ...
  4. Fixed Exchange Rate

    A country's exchange rate regime under which the government or ...
  5. Key Currency

    The currency used as a reference in an international transaction ...
  6. Joint Float

    Two or more countries agreeing to keep their currencies at a ...
RELATED FAQS
  1. How does inflation affect the exchange rate between two nations?

    Understand how inflation can affect foreign exchange rates of a currency and how it is just one of many economic factors ... Read Answer >>
  2. What economic indicators are most used when forecasting an exchange rate?

    Discover what economic indicators are most widely used to forecast a country’s exchange rate and how various factors influence ... Read Answer >>
  3. What is foreign exchange?

    Foreign exchange, or Forex, is the conversion of one country's currency into that of another. In a free economy, a country's ... Read Answer >>
  4. What is the difference between a nation's current account deficit and its currency ...

    Learn the respective meanings of the two terms, current account deficit and currency valuation, and understand the relationship ... Read Answer >>
  5. What are key benefits to a country that has engaged in a policy of currency depreciation?

    Learn about key benefits to a country engaging in a policy of currency depreciation, such as smaller trade deficits, employment ... Read Answer >>
  6. How does a capital account illustrate the strength of investment markets for a country?

    Understand what a country's capital account is and how the capital account level can be used to gauge the strength of investment ... Read Answer >>
Hot Definitions
  1. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  2. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  3. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  4. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  5. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  6. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
Trading Center