Trading factors
Interest and inflation rates
Two of the biggest factors that need to be looked at when getting involved in Forex trading are the interest rates and the inflation rate. These have a direct impact on the value of a country’s currency. This is one of the reasons why economics is an essential background knowledge base for people trading in currency. Another major theory is the PPP or Purchasing power parity. This is an economic theory, which states that the price level between two countries should be the same after exchange rate adjustment. This is based on the law of one price. The law of one price states that the cost of an identical good should be the same no matter where it is in the world based on this if there is a large difference in the price between the items in two different countries after the exchange rate adjustment then something called an arbitrage opportunity is created. This is because the product can be obtained from the country that is offering it for the lower price. So now, you may be asking exactly how this theory would apply when it comes to trading the currency of the countries. It actually involves a small mathematical equation. Expected Currency appreciation is equal to the following, inflation rate of one country minus the inflation rate of another divided by the inflation rate of the second country plus 1. For example if ABC country has an inflation rate of 10% and GHI has an inflation rate of 5% you would take ABC’s inflation rate as a decimal 0.10 subtract 0.05 which would give you 0.05. Then you would take GHI’s inflation rate of 0.05 and add 1 to it. This will give you 1.05. Take the first number 0.05 divide by the second number 1.05 and you get the Expected Currency Appreciation, which is 4.76%. This tells you the amount by which a currency is expected to change based on inflation.
This is only one of the formulas used in order to determine the value of trading a particular set of currency pairs. There are several others, the interest rate parity. This is similar to PPP but uses a slightly different formula and suggests that there is no such thing as arbitrage opportunities. Under this theory, the purchase of an investment in one country should have a return that equals that of the same investment purchase in another country otherwise the exchange rate would have to be adjusted in order to make up the difference between the returns of the two countries.
The international Fisher Effect
The International Fisher Effect states that an exchange rate between two countries should change by a similar amount to the difference between these two countries interest rates. If the nominal rate of one of the two countries is lower than the nominal rate of the other than the lower nominal rate, country should have an appreciation in their currency against the country with the higher rate.
Other tools and models for FX trading
The Balance of Payments is another tool used in Forex trading to determine whether or not a country is going to appreciate or depreciate. These theories are used to determine if based on current conditions a currency pair is worth investing in. Given that fact, this particular theory is one of the more important ones.
The Real Interest Rate Differentiation model states that countries that have higher interest rates, higher real interest rates that are will see the currency of their country appreciate against countries that have a lower real interest rate. This is why investors have a tendency to move money around the world. They are placing the money in locations that have a higher interest rate in order to generate higher returns.
Asset Market Model helps to look at the money that is coming into a country from investors that are from other countries. It looks at what investors are purchasing, stocks, bonds or other financial instruments. It is a long-standing fact that a large inflow of foreign investors usually means that the price of the currency is expected to increase.
Monetary model, this focuses on the monetary policy of the country itself to help determine the exchange rate of that countries currency. The policy deals with the money supply of that country which is actually determined by the interest rate and the amount of currency, which is being printed. This is important because the more money a country is printing and putting out the greater the chance for devaluation. This of course affects the outlook of trading in that country’s currency, which is why it is an important aspect of Forex trading research.
Finally, when it comes to data that is used for Forex trading and that needs to be looked at there is the rest of the economic data for a country. While the theories work on moving the currency over a long period of time it is the short term, daily and weekly information that has a more apparent impact for individuals who are Forex trading. Some of the short-term economic data, which needs to be considered and analyzed before making a commitment to work in a particular currency pair are the GDP or gross domestic product, this is the amount of money the country makes. Changes in the following, interest rates, inflation, unemployment, consumer confidence, GDP and political stability can all have a large impact on the exchange rate and the worth of the currency that you as a Forex trader are working with. This is what knowing the current state of the countries involved is essential.
Luckily, thanks to the interest the majority of this type of information is available on the internet. You can find current reports on various countries usually located on either economic sites or the websites for the countries themselves. The ability of news to be transmitted world wide means that you can be up to date on everything that is not only effecting a particular country but effecting it down to a city or town since most newspapers also have online portals.