Monday, September 15, 2008, 10:06 PM
[
forex trading ]
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The
two primary approaches of analyzing currency markets are fundamental
analysis and technical analysis. Fundamentals focus on financial and
economic theories, as well as political developments to determine
forces of supply and demand. One clear point of distinction between
fundamentals and technicals is that fundamental analysis studies the
causes of market movements, while technical analysis studies the
effects of market movements.
Fundamental analysis comprises the
examination of macroeconomic indicators, asset markets, and political
considerations when evaluating one nation's currency relative to
another. Macroeconomic indicators include figures such as growth rates;
as measured by Gross Domestic Product, interest rates, inflation,
unemployment, money supply, foreign exchange reserves and productivity.
Asset markets comprise stocks, bonds, and real estate. Political
considerations impact the level of confidence in a nation's government,
the climate of stability and level of certainty.
Sometimes
governments stand in the way of market forces impacting their
currencies, and hence, intervene to keep currencies from deviating
markedly from undesired levels. Currency interventions are conducted by
central banks and usually have a notable, albeit a temporary, impact on
FX markets. A central bank could undertake unilateral purchases/sales
of its currency against another currency; or engage in a concerted
intervention in which it collaborates with other central banks for a
much more pronounced effect. Alternatively, some countries can manage
to move their currencies, merely by hinting, or threatening to
intervene.
Purchasing Power Parity
The
PPP theory states that exchange rates are determined by the relative
prices of similar baskets of goods. Changes in inflation rates are
expected to be offset by equal but opposite changes in the exchange
rate. Take the classic example of hamburgers. If the burger costs $2.00
in the US and £1.00 in the UK, then according to PPP, the £-$ exchange
rate must be 2 dollars per one British pound.
If the prevailing
market exchange rate is $1.7 per British pound, then the pound is said
to be undervalued and the dollar overvalued. The theory then postulates
that the two currencies will eventually move towards the 2:1 relation.
PPP's
major weakness is that it assumes goods are easily tradable, with no
costs to trade such as tariffs, quotas or taxes. Another weakness is
that it applies only for goods and ignores services, where room for
differences in value is significant. Furthermore, there are several
factors besides inflation and interest rate differentials impacting
exchange rates, such as economic releases/reports, asset markets and
political developments. There was little empirical evidence of the
effectiveness of PPP prior to the 1990s. Thereafter, PPP was seen to
have worked only in the long term (3-5 years) when prices eventually
correct towards parity.
IRP
states that an appreciation (depreciation) of one currency against
another currency must be neutralized by a change in the interest rate
differential. If US interest rates exceed Japanese interest rates, then
the US dollar should depreciate against the Japanese yen by an amount
that prevents riskless arbitrage. The future exchange rate is reflected
into the forward exchange rate stated today. In our example, the
forward exchange rate of the dollar is said to be at discount because
it buys fewer Japanese yen in the forward rate than it does in the spot
rate. The yen is said to be at a premium.
IRP showed no proof of
working after the 1990s. Contrary to the theory, currencies with higher
interest rates characteristically appreciated rather than depreciated
on the reward of future containment of inflation and a higher yielding
currency.
- Balance of Payments Model
This
model holds that a foreign exchange rate must be at its equilibrium
level—the rate that produces a stable current account balance. A nation
with a trade deficit will experience a reduction in its foreign
exchange reserves, which ultimately lowers (depreciates) the value of
its currency. The cheaper currency renders the nation' goods (exports)
more affordable in the global market place while making imports more
expensive. After an intermediate period, imports are forced down and
exports rise, thus stabilizing the trade balance and the currency
towards equilibrium.
Like PPP, the balance of payments model
focuses largely on tradable goods and services, while ignoring the
increasing role of global capital flows. In other words, money is not
only chasing goods and services, but to a larger extent, financial
assets such as stocks and bonds. Such flows go into the capital account
item of the balance of payments, thus, balancing the deficit in the
current account. The increase in capital flows has given rise to the
Asset Market Model.
Accumulation/Distribution (AD)
Accumulation Distribution is a price and volume indicator.
-
When the Accumulation/Distribution moves up, it shows that the security
is being accumulated (Buying), as most of the volume is associated with
upward price movement.
- When the indicator moves down, it
shows that the security is being distributed (Selling), as most of the
volume is associated with downward price movement.
- Divergences
between the Accumulation/Distribution indicator and the price of the
security indicate the upcoming change of prices.
