Forex Theories, Formulas, Models

The Forex offers the speculative trader an exciting and refreshingly accessible array of strategies and perspectives for developing a personal trading style. Keep in mind that this kind of trading might not be suitable for all investors. There is a substantial risk of loss in all trading. The major pairs respond well to technical analysis but significant economic or political news can put the spotlight on fundamentals. And while it may take specialized knowledge to understand a USDA crop report, many people are already familiar with the type of news that may move the Forex market.

Gaining an understanding of basic economic principles will enhance your grasp of how fundamentals may have an impact on the Forex currency pairs.

Fundamental factors, seasonal and weather trends, daily news, and other current events may have already been factored into the markets.

Purchasing Power Parity

Purchasing power parity is a theory that identical goods could be bought for the same price in different markets when transaction costs are excluded. The concept may equalize to factor in the buying power of different currencies in an “absolute” version or account for different inflation rates in different countries in a “relative” version of the theory. Purchasing Power Parity may be used as an indictor of the level of poverty in a given country. A limitation is the variance that may exist in the compared goods themselves which may not always be truly identical. Quality differences are difficult to factor into a Purchasing Power Parity calculation, thereby creating a potential for a margin of error.

The Purchasing Power Parity exchange rate attempts to account for consistent deviations between two markets, for example, the price of basic commodity items is likely much lower in a country where incomes are lower. Calculating the Purchasing Power Parity will require the identification of goods that are available in both economies being compared.

The Economist magazine popularized what it calls the “Big Mac Index,” calculating a Purchasing Power Parity rate for the McDonald’s specialty hamburger, an item that can be considered generally uniform throughout the world. As it will be produced locally wherever it is sold, costs that go into the Big Mac may be calculated relative to the consistent deviations that may exist for raw materials and services in each economy being compared. A limitation of the Index, however, is the fact that in emerging nations a Big Mac is not a cheap, fast-food meal but rather a Western luxury item that is out of reach for much of the populace.

Interest Rate Parity

Interest Rate Parity is a theory that the difference between the current spot exchange rate and the forward exchange rate should be the same as the difference between the interest rates of two countries. The theory suggests that the potential to profit is equal between the two models. An arbitrage opportunity would exist in the absence of interest rate parity.

International Fisher Effect

The International Fisher Effect hypothesizes that nominal interest rates are indicators of the real rate of return and the expected rate of inflation. Named for economist Irving Fisher who developed the model in the 1930s, the International Fisher Effect applies an interest rate model as a leading indicator for predicting spot currency rates as far as 12 months into the future. Fisher proposed using the interest rate model over an inflation model on his assumption that inflation is an element of the interest rate and therefore already accounted for in exchange rate projections.

As an indicator of currency exchange rates, the International Fisher Effect would predict that when two currencies are compared, the currency value that will weaken will be the country with the higher nominal interest rate. For investors in either country, however, an average return should result because of appreciation of the currency of the country with the lower interest rate.

Balance of Payments Theory

The Balance of Payments calculates the amount of imports and exports to determine how much money is flowing in and out of a country. With respect to currency rates, the supply and demand for a country’s currency is indicated by the debit and credit items in the Balance of Payments. Supply is indicated by credits to the Balance of Payments from exports and foreign investment coming into the country; conversely, demand is indicated by debits to the Balance of Payments from imports and investments made abroad.

The fundamentals of supply and demand would indicate therefore that when demand exceeds supply, a country’s currency value will rise. When supply exceeds demand, currency value may be expected to decline. A positive Balance of Payments may be viewed an indication of economic stability and healthy foreign investment.

Real Interest Rate Differentiation Model

The Real Interest Rate Differentiation Model makes a simple assumption about human nature: That a higher-paying investment vehicle will attract more investment. Changes in the interest rate can have a significant impact on exchange rates as a country’s money will be determined to offer a higher or lower yield. Maintaining a low interest rate has been used as a means of central bank intervention for controlling an exchange rate. A country may choose to depreciate its own currency as a means of making its exports more attractive on the world market. Conversely, raising interest rates will usually result in the appreciation of a country’s currency. An increase in demand for a country’s currency can result when foreign investors notice a high yield.

Asset Market Model

The Asset Market Model was developed to reflect the changing influences on today’s foreign exchange market. Significant amounts of foreign investment may now flow into a country’s capital markets in addition to investments in its goods and services or infrastructure. Investment into a capital market will trigger an exchange of the invested foreign currency into the country’s domestic currency. An increase of this type of foreign investment is expected to result in an appreciation of the country’s currency. The foreign investor has the potential to gain not only from a potential increase in the value of the investment itself, but also from the rise in the value of the country’s currency.

Monetary Model

The Monetary Model correlates fundamentals of supply and demand to the value of a country’s currency. The Model states that the value of money will fluctuate with changes in the money supply, inflation rates, interest rates, and income levels. Traders who follow the Monetary Model would look for an increase in exchange rates should there be a decrease in the money supply, a decrease in inflation or an increase in income levels. Conversely, a decline in exchange rates would be anticipated when there is an increase in the money supply, an increase in inflation or a decrease in income levels. Past performance is not indicative of future results.