Understanding Fundamental Analysis

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The Basic Theories of Fundamental Analysis

Purchasing Power Parity (PPP)

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.

Interest Rate Parit (IRP)

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.

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.

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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