As I mentioned before, fundamental analysis focuses on what and why to buy certain financial instruments. This kind of analysis is based on theoretical models of exchange rate determination and on economic indicators (factors) that affect the forex market. In this chapter, I want to point out a couple of well-known theories of exchange rate determination. They will help you understand what techniques fundamental analysts use while analyzing what affects global markets. The most popular theories are presented below.
Purchasing Power Parity Theory (PPP)
Purchasing power parity (PPP) states that the exchange rate between two currencies is in equilibrium when their purchasing power is the same in each of the two countries. It basically states that the exchange rate between two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When prices in one country increase (inflation), the country’s currency has to depreciate in order to return to PPP.
The basis for PPP is the so called "law of one price". Excluding transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency. For example, a particular DVD set that sells for 750 Euros [EUR] in Paris should cost 500 US Dollars [USD] in Charlotte when the exchange rate between Euro zone and the US is 1.50 EUR/USD. If the price of the DVD in Paris was only 700 EUR, consumers in Charlotte would rather buy the DVD set in Paris. If this arbitrage works out at a large scale, the US consumers buying European goods will bid up the value of the Euro, thus making European goods more costly to them. This process continues until the goods have again the same price. There are three factors that need to be taken into account with this law of one price:
1. As I mentioned above, transportation costs, barriers to trade, and other transaction costs, can be significant.
2. There must be competitive markets for the goods and services in both countries.
3. The law of one price only applies to tradeable goods; items like houses, and many services that are local, are usually not traded between countries.
There are two versions of the Purchasing Power Parity Theory: absolute PPP and relative PPP. Absolute PPP was described in the text above; it refers to the equalization of price levels across countries. The exchange rate between the Euro zone and United States is equal to the price level in the Euro zone divided by the price level in the United States. As an example, let’s say that the price level ratio is at 1.3 but the exchange rate EURUSD is at 1.5, PPP theory implies that the Euro will appreciate (gain value) and the USD will have to depreciate (get weaker) to reach the 1.5 level.
Relative PPP refers to rates of changes of price levels, that is, inflation rates. This theory holds that the rate of appreciation of a currency is equal to the difference in inflation rates between the foreign and the home country. For example, if the Euro zone has an inflation rate of 3% and the US has an inflation rate of 5%, the US Dollar will depreciate against the Euro by 2% per year.
Interest Rate Parity (IRP)
As early as the period of the gold standard, monetary policymakers found that exchange rates were influenced by changes in monetary policy. The rise of one country’s interest rate is usually followed by the appreciation of the country’s currency, and a fall in the country’s interest rate is followed by a depreciation of the country’s currency. This indicates that the price of assets plays a role in exchange rate fluctuations. The interest rate parity condition was developed by Keynes in 1923, as the interest rate parity, to link the exchange rate, interest rate and inflation. This theory also has two variations: covered interest rate parity (CIRP) and uncovered interest rate parity (UCIRP). CIRP describes the relationship of the spot market and forward market exchange rates with interest rates on bonds in two economies. UCIRP describes the relationship of the spot and expected exchange rate with nominal interest rates on bonds in two economies.
Theory of Elasticity
The theory of elasticity basically stays that an exchange rate is the price of foreign exchange that keeps the balance of payments in equilibrium. Let’s show it on an example: the trade balance in one country (X) is negative when imports are big. This in turn leads to depreciation of the country’s currency, making exports cheaper. In the end, foreign income declines but domestic income raises. This increasing domestic income of course will cause an increase in domestic consumption of both foreign and domestic goods. Demand for foreign currency of country (X) will rise, so country (Y) will experience a decline of foreign income causing a decrease of domestic consumption of both foreign and domestic goods and services. This will lead to a lower demand for country’s (Y) currency.
The theory of elasticity works better in the long-term since in the short-term the exchange rate is more inelastic and additional factors might affect it.
The Portfolio Balance Theory
Under this theory, demand for money depends on demand for financial assets, not for the currency itself. So, increased demand for a class of assets in one country, leads to a higher demand for that country’s currency. It happens oftentimes when certain assets become very attractive to investors.
All these theories just set the ground for understanding how the forex markets work. There are so many factors that affect interest rates that it is difficult to track all of them. Exchange rates always fluctuate due to disturbances on the markets, speculative forces, and short-term investing. Since commodities markets adjust slower than capital markets, we can assume that in the short-term currencies are affected by capital markets, while in the long-run by commodities markets.
Adam Narczewski
X-Trade Brokers Dom Maklerski S.A.
adam.narczewski@xtb.pl