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Forex Tutorial: What is Forex Trading? There is a great deal of academic theory revolving around currencies. While often not applicable directly to day-to-day trading, it is helpful to understand the overarching ideas behind the academic research. The main economic theories found in the foreign exchange deal with parity conditions.
A parity condition is an economic explanation of the price at which two currencies should be exchanged, based on factors such as inflation and interest rates. The economic theories suggest that when the parity condition does not hold, an arbitrage opportunity exists for market participants. The basis of this theory is the law of one price, where the cost of an identical good should be the same around the world. 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.
PPP, in that it suggests that for there to be no arbitrage opportunities, two assets in two different countries should have similar interest rates, as long as the risk for each is the same. 2′ represents the interest rate in country 2. 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. 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. A country’s balance of payments is comprised of two segments – the current account and the capital account – which measure the inflows and outflows of goods and capital for a country.
The balance of payments theory looks at the current account, which is the account dealing with trade of tangible goods, to get an idea of exchange-rate directions. If a country is running a large current account surplus or deficit, it is a sign that a country’s exchange rate is out of equilibrium. To bring the current account back into equilibrium, the exchange rate will need to adjust over time. On the other hand, a surplus would lead to currency appreciation. BRA represents the reserves account balance. The Real Interest Rate Differential Model simply suggests that countries with higher real interest rates will see their currencies appreciate against countries with lower interest rates.
The reason for this is that investors around the world will move their money to countries with higher real rates to earn higher returns, which bids up the price of the higher real rate currency. The Asset Market Model looks at the inflow of money into a country by foreign investors for the purpose of purchasing assets such as stocks, bonds and other financial instruments. If a country is seeing large inflows by foreign investors, the price of its currency is expected to increase, as the domestic currency needs to be purchased by these foreign investors. This theory considers the capital account of the balance of trade compared to the current account in the prior theory. The Monetary Model focuses on a country’s monetary policy to help determine the exchange rate. A country’s monetary policy deals with the money supply of that country, which is determined by both the interest rate set by central banks and the amount of money printed by the treasury.
Countries that adopt a monetary policy that rapidly grows its monetary supply will see inflationary pressure due to the increased amount of money in circulation. This leads to a devaluation of the currency. These economic theories, which are based on assumptions and perfect situations, help to illustrate the basic fundamentals of currencies and how they are impacted by economic factors. 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. 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. Listed below are a number of economic indicators that are generally considered to have the greatest influence – regardless of which country the announcement comes from.