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Fundamental AnalysisFundamental analysis is based on using theoretical
models of currency price formation and investigating major factors (not only
economical) which influence the currency rates. Fundamental analysis lies in
examining macroeconomic indexes and indicators, markets of securities, and
political factors for one national currency in correlation to another currency.
Macroeconomic indicators include the growth of GNP, interest rate, inflation,
unemployment, money reserves, currency reserves, and productivity of work.
Securities' markets stand for shares, bonds, and real estate. Political factors
reflect the level of credibility to given government, its stability, confidence
of others in it.
Sometimes the governments interfere into currency
forming forces of the market to prevent them from unfavorable tendencies. This
interference is performed by Central Banks, and they may have sufficient impact
upon the market situation. Central Bank can buy/sell a great amount of its
national currency or take part in coordinated actions with other Central Banks
for getting bigger effect on the market.
There are several theories for
currency price formation.
- 1. Parity of purchasing capacity. This theory states that currency
rates are defined by relative prices of "basket of goods" - a set of certain
products. Parity of purchasing capacity has two versions: absolute and relative.
According to absolute version, the exchange rates are defined by a simple
correlation between general price level of two countries (this general price
level shows single average price for all the goods which are produced inside the
country). This version can be used only if it is possible to find countries
which produce and consume the same goods. Plus, absolute version does not take
into account transporting costs, expenses for breaking the trading boundaries
and importance of trade marks.
Relative version proves that percentage
change in currency rate within certain period of time should be equal percentage
change in price level inside this country and abroad. This version has its own
flaws: problem of trading limits, averaging prices when calculating their
indexes. Parity of purchasing capacity and its theory do not include the prices
for services, and possible currency rate changes (which often change
irrespectively of financial and political reasons).
- 2. Flexibility theory. According to this theory the currency exchange
rate shows the price of national currency which makes the trading balance of
this country more equal (i.e. more balanced). The country with trading deficit
will be losing reserves of foreign currency: this will cause devaluation of
national currency. Cheaper currency makes the goods of this country cost lower
on the world market, whereas the import becomes more expensive. After a while
the amount of import decreases, export gets more trading volumes, and the
trading balance finally comes to a balance together with the national currency.
This theory also has got its drawbacks. The currency rate is less flexible
during short periods of time, only longer time spans show good currency
flexibility. Moreover, additional factors affecting the principles of this
theory arise constantly.
- 3. Equal interest rates. This theory implies that revaluation or
devaluation of one currency against another should be neutralized by changes in
the level of interest rates. The currency with higher interest rate will be
losing its value is respect to the currency with lower interest rate. However,
this theory finds no examples recently. On the contrary, the currencies with
higher interest rates grew in price. But this may be caused by huge power of
inflation expectations.
- 4. Theory of securities' market. The swift growth in trading volumes
of securities (shares and bonds) has changed the attitude of analysts and
traders to currencies. The amount and size of currency market transactions, made
from international trading of securities, is really huge in comparison with
turnovers from goods and services. Theory of securities' market treats
currencies as prices for shares and bonds, under the circumstances of effective
financial market. Due to this, currency markets become more closely related to
the securities' markets (especially to shares).
Another important
factor is represented by the dominating expectations of the market. Timely
receipt of information and its adequate analysis can help a lot in increasing
the effective market trading.
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