Fundamental analysis by trading on Forex

Two types of analysis are used for market movements forecasting: fundamental, and technical (the chart study of past behavior of currencies prices). The fundamental one focuses on theoretical models of exchange rate determination and on major economic factors and their likelihood of affecting foreign exchange rates.

Theories of exchange rate determination
Purchasing power parity states that the price of a good in one country should equal the price of the same good in another country, exchanged at the current rate—the law of one price. There are two versions of the purchasing power parity theory: the absolute version and the relative version. Under the absolute version, the exchange rate simply equals the ratio of the two countries' general price levels, which is the weighted average of all goods produced in a country. However, this version works only if it is possible to find two countries, which produce or consume the same goods. Moreover, the absolute version assumes that transportation costs and trade barriers are insignificant. In reality, transportation costs are significant and dissimilar around the world. Trade barriers are still alive and well, sometimes obvious and sometimes hidden, and they influence costs and goods distribution. Finally, this version disregards the importance of brand names. For example, cars are chosen not only based on the best price for the same type of car, but also on the basis of the name ("You are what you drive").

Under the PPP relative version, the percentage change in the exchange rate from a given base period must equal the difference between the percentage change in the domestic price level and the percentage change in the foreign price level. The relative version of the PPP is also not free of problems: it is difficult or arbitrary to define the base period, trade restrictions remain a real and thorny issue, just as with the absolute version, different price index weighting and the inclusion of different products in the indexes make the comparison difficult and in the long term, countries' internal price ratios may change, causing the exchange rate to move away from the relative PPP. In conclusion, the spot exchange rate moves independently of relative domestic and foreign prices. In the short run, the exchange rate is influenced by financial and not by commodity market conditions.

Theory of elasticities holds that the exchange rate is simply the price of foreign exchange that maintains the balance of payments in equilibrium. In other words, the degree to which the exchange rate responds to a change in the trade balance depends entirely on the elasticity of demand to a change in price. For instance, if the imports of country A are strong, then the trade balance is weak. Consequently, the exchange rate rises, leading to the growth of country A's exports, and triggers in turn a rise in its domestic income, along with a decrease in its foreign income. Whereas a rise in the domestic income (in country A) will trigger an increase in the domestic consumption of both domestic and foreign goods and, therefore, more demand for foreign currencies, a decrease in the foreign income (in country B) will trigger a decrease in the domestic consumption of both country B's domestic and foreign goods, and therefore less demand for its own currency. The elasticities approach is not problem-free because in the short term the exchange rate is more inelastic than it is in the long term and additional exchange rate variables arise continuously, changing the rules of the game.

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Ditulis oleh William Perkasa pada tanggal Wednesday, February 18, 2009