Fundamental Analysis – an Introduction

Fundamental analysis is the study of financial, economic, social, political and crisis data; that together forms the total economic situation of a particular economy for the purpose of forecasting future price movements.
As stated in the Technical analysis section, there are indeed two basic schools of thought when it comes to forecasting future prices – Technical and Fundamental. (Refer to Technical Analysis), however there are very few pure technicians or fundamentalists. Technical analysts cannot really ignore the effect and timing of economic announcements and fundamental analysts cannot really ignore various signals derived from the study of historic prices.

It is practically impossible to take into consideration all the myriads of different economic announcements that are regularly released, yet alone all the other financial, social and political events that occur constantly around the world. Although, if one were to understand the basic fundamentals and know about the important economic releases, the level of understanding of the various financial markets would improve substantially, even price shifts would more often then not make more sense while they are occurring.

In order to make use of the economic data that is being released and still have time to come up with an effective trading strategy it may be more appropriate for us to concentrate on the markets’ main movers rather then try to cover the entire scope of all the economic events.

Fundamental Analysis – Exchange Rate Determination Theories

There are several theories as to how exchange rates should determine themselves. We will very briefly mention them here to allow our readers the opportunity for further reading. Be that as it may, these economic theories have many constraints and assumptions that do not allow them to be of any real help in the real world. The theories do not take into account real world phenomena such as the existence of trade constraints, costs and time of transportation, brand names and so on.

The Purchasing Power Parity (PPP) Theory

The absolute purchasing power parity (PPP) theory is based on the “law of one price”, which states that identical goods will have the same price in two countries when the exchange rate is at equilibrium. If there are price discrepancies the world’s arbitrageurs will balance the market out, whether by changing the price of the goods themselves in the different countries or by the adjustment of the exchange rate.

The Theory of Elasticities

The theory of elasticities maintains that the exchange rate will adjust itself according to the changes in the balance of payments. For example, if the imports of country A are strong, then the trade balance is weak., therefore the exchange rate will rise which will lead to the growth of country A’s exports and then a rise in its domestic income, which will eventually adjust the exchange.

Other Theories include

The Modern Fiscal Theories on Short-Term Exchange Rate Volatility
The Portfolio-Balance Approach
Synthesis of Traditional and Modern Monetary Views

Financial Factors

Financial factors essentially refer to changes in the governments monetary and fiscal policies. These changes have a major effect on the currency markets that lead from the changes in the local economy. The most widely anticipated financial factor are interest rate changes and related announcements, any change in interest rates will adjust the interest rate differential between corresponding currency pairs.

Political and Social Crises Influence

This goes without saying as a major source of influence on the FX markets. However, since this is a crisis it can not be factored in to any currency price, and a major crisis will often create a very sharp and very fast correction. There will often be reverse adjustments within seconds as other players react, it may take several minutes before the market picks an appropriate direction due to a lack of volume and liquidity.

Economic Indicators

Economic indicators remain the main focus of fundamental analysts. They are quantitative announcements released as data reflecting the financial, economical and social atmosphere of an economy. Major government and some private agencies release these announcements at regular known intervals (usually monthly). Many private groups speculate on the anticipated release and these expectations quickly become incorporated into the current market price. When the economic indicator is released the difference between the actual release and the anticipated release is the key factor. A large change may have zero affect on the market if it was already anticipated weeks earlier. These statistics are used by many to monitor the health and strength of an economy. With so many players anticipating the release, there is usually an increase in volatility in and around announcement time, this increase in volatility will often create serious price movements and not necessarily in one direction.