Forex Walkthrough


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:

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. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  2. Chart Advisor

    ChartAdvisor for November 27 2015

    Weekly technical summary of the major U.S. indexes.
  3. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  4. Chart Advisor

    Pay Attention To These Stock Patterns Playing Out

    The stocks are all moving different types of patterns. A breakout could signal a major price move in the trending direction, or it could reverse the trend.
  5. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  6. Stock Analysis

    The Biggest Risks of Investing in Pfizer Stock

    Learn the biggest potential risks that may affect the price of Pfizer's stock, complete with a fundamental analysis and review of other external factors.
  7. Stock Analysis

    Why did Wal-Mart's Stock Take a Fall in 2015?

    Wal-Mart is the largest company in the world, with a sterling track-record of profits and dividends. So why has its stock fallen sharply in 2015?
  8. Investing News

    Should You Invest in Disney Stock Before Star Wars?

    The force is strong with Disney stock, as it continues to make gains going into the launch of EP7. But is this pricey stock a good buy at these levels?
  9. Investing

    10 Cheap Vacations for the Ultimate Foodie

    If you are a foodie then explore one of these destinations in 2016.
  10. Investing News

    Silicon Valley Startups Fly into Space

    Space enthusiasts are in for an exciting time as Silicon Valley startups take on the lucrative but expensive final frontier.
  1. Dead Cat Bounce

    A temporary recovery from a prolonged decline or bear market, ...
  2. Currency

    Currency is a generally accepted form of money, including coins ...
  3. Hedge

    Making an investment to reduce the risk of adverse price movements ...
  4. Confirmation

    The use of an additional indicator or indicators to substantiate ...
  5. Qualitative Analysis

    Securities analysis that uses subjective judgment based on nonquantifiable ...
  6. Capitalization Rate

    The rate of return on a real estate investment property based ...
  1. Can hedge funds trade penny stocks?

    Hedge funds can trade penny stocks. In fact, hedge funds can trade in just about any type of security, including medium- ... Read Full Answer >>
  2. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  3. How do mutual funds work in India?

    Mutual funds in India work in much the same way as mutual funds in the United States. Like their American counterparts, Indian ... Read Full Answer >>
  4. Are UTMA accounts escheatable?

    Like most financial assets held by institutions such as banks and investment firms, UTMA accounts can be escheated by state ... Read Full Answer >>
  5. What are the dormancy and escheatment rules for stock accounts?

    While the specific dormancy and escheatment rules for stock accounts vary by state, all states provide for the escheatment ... Read Full Answer >>
  6. Does mutual fund manager tenure matter?

    Mutual fund investors have numerous items to consider when selecting a fund, including investment style, sector focus, operating ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center