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Thread: Fundamental Analysis

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    Default Fundamental Analysis

    Fundamental Analysis

    The two primary approaches of analyzing currency markets are fundamental analysis and technical analysis. Fundamentals focus on financial and economic theories, as well as political developments to determine forces of supply and demand. Technicals look at price and volume data to determine if they are expected to continue into the future. Technical analysis can be further divided into 2 major forms: Quantitative Analysis: uses various statistical properties to help assess the extent of an overbought/oversold currency, Chartism: which uses lines and figures to identify recognizable trends and patterns in the formation of currency rates. One clear point of distinction between fundamentals and technicals is that fundamental analysis studies the causes of market movements, while technical analysis studies the effects of market movements.
    Fundamental analysis comprises the examination of macroeconomic indicators, asset markets and political considerations when evaluating a nations currency in terms of another. Macroeconomic indicators include figures such as growth rates; as measured by Gross Domestic Product, interest rates, inflation, unemployment, money supply, foreign exchange reserves and productivity. Asset markets comprise stocks, bonds and real estate. Political considerations impact the level of confidence in a nations government, the climate of stability and level of certainty.

    Sometimes governments stand in the way of market forces impacting their currencies, and hence, intervene to keep currencies from deviating markedly from undesired levels. Currency interventions are conducted by central banks and usually have a notable, albeit a temporary impact on FX markets. A central bank could undertake unilateral purchases/sales of its currency against that another currency; or engage in concerted intervention in which it collaborates with other central banks for a much more pronounced effect. Alternatively, some countries can manage to move their currencies, merely by hinting, or threatening to intervene.

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    The Basic Theories

    1.Purchasing Power Parity
    2.Interest Rate Parity
    3.Balance of Payments Model
    4.Asset Market Model

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    1. Purchasing Power Parity
    The PPP theory states that exchange rates are determined by the relative prices of similar baskets of goods. Changes in inflation rates are expected to be offset by equal but opposite changes in the exchange rate. Take the classic example of hamburgers. If the burger costs $2.00 in the US and £1.00 in the UK, then according to PPP, the £-$ exchange rate must be 2 dollars per one British pound. If the prevailing market exchange rate is $1.7 per British pound, then the pound is said to be undervalued and the dollar overvalued. The theory then postulates that the two currencies will eventually move towards the 2:1 relation. PPP’s major weakness is that it assumes goods are easily tradable, with no costs to trade such as tariffs, quotas or taxes. Another weakness is that it applies only for goods and ignores services, where room for differences in value is significant. Furthermore, there are several factors besides inflation and interest rate differentials impacting exchange rates, such as economic releases/reports, asset markets and political developments. There was little empirical evidence of the effectiveness of PPP prior to the 1990s. Thereafter, PPP was seen to have worked only in the long term (3-5 years) when prices eventually correct towards parity.

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    2. Interest Rate Parity
    IRP states that an appreciation (depreciation) of one currency against another currency must be neutralized by a change in the interest rate differential. If US interest rates exceed Japanese interest rates then the US dollar should depreciate against the Japanese yen by an amount that prevents riskless arbitrage. The future exchange rate is reflected into the forward exchange rate stated today. In our example, the forward exchange rate of the dollar is said to be at discount because it buys fewer Japanese yen in the forward rate than it does in the spot rate. The yen is said to be at a premium.
    IRP showed no proof of working after the 1990s. Contrary to the theory, currencies with higher interest rates characteristically appreciated rather than depreciated on the reward of future containment of inflation and a higher yielding currency

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    3. Balance of Payments Model
    This model holds that a foreign exchange rate must be at its equilibrium level—the rate that produces a stable current account balance. A nation with a trade deficit will experience a reduction in its foreign exchange reserves which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation’ goods (exports) more affordable in the global market place while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium.
    Like PPP, the balance of payments model focuses largely on tradable goods and services, while ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. Such flows go into the capital account item of the balance of payments, thus, balancing the deficit in the current account. The increase in capital flows has given rise to the Asset Market Model.

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    4. Asset Market Model
    The explosion in trading of financial assets (stocks and bonds) has reshaped the way analysts and traders look at currencies. Economic variables such as growth, inflation and productivity are no longer the only drivers of currency movements. The proportion of foreign exchange transactions stemming from cross border-trading of financial assets has dwarfed the extent of currency transactions generated from trading in goods and services.
    The asset market approach views currencies as asset prices traded in an efficient financial market. Consequently, currencies are increasingly demonstrating a strong correlation with asset markets, particularly equities.

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    The Dollar & US Asset markets-1999

    In Summer of 1999, many pundits argued for the fall of the dollar against the euro on the grounds of the expanding US current account deficit, and an overvalued Wall Street. That was based on the rationale that non-US investors would begin withdrawing their funds from US stocks and bonds into more economically sound markets thus, weighing significantly on the dollar. Yet, such fears have lingered since the early 1980s when the US current account soared to a record high 3.5% of GDP.

    Just like in the 1980s, foreign investors’ appetite in US assets have remained largely unhinged. Unlike in the 1980s, the 1990s witnessed the disappearance of the budget deficit. Growth in foreign holdings of US Treasuries may have slowed, but it remained more than offset by a prodigious inflow into US stocks. In the case of a burst in the US bubble, the most probable alternative for non-US investors would likely be safer US treasuries, rather than Eurozone or UK stocks, which are likely to be just as battered during such an event. This had already taken place during the crises of November 1998, and the equity scare of December 1996 prompted by Fed Chairman Greenspan’s "irrational exuberance" speech. In the former case, net foreign treasury buying almost tripled to $44 bln, while in the latter case it soared more than 10 times, reaching $25 bln.

    Throughout the past two decades, the balance of payments approach in assessing the dollar’s behavior has given way to the asset market approach. An improvement in Eurozone economic fundamentals will certainly help the young currency recover some lost ground, but it will take more than simple fundamentals to sustain such a recovery. There remains the issue of ECB credibility; which has so far had an inverse relation with the frequency of verbal support for the euro. Looming risks of government stability in the Eurozone big 3 (Germany, France and Italy) and the sensitive issue of expanding membership in the European Monetary Union are also seen as potential obstacles to the single currency.

    At the time, the dollar remained steady thanks to the following ingredients: non-inflationary growth, "safe-haven" nature of US asset markets and the aforementioned Euro risks.

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    good job my friend.

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