August 6, 2013
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An Introduction To Foreign Exchange Trading

 Foreign Exchange Trading

An Introduction To Foreign Exchange Trading

The foreign exchange trading market is an exciting market.  This used to be the exclusive domain of central banks, large banks and financial institutions and hedge funds.  It has now been opened up to the individual investor who wishes to trade in currencies.

The daily fluctuations are normally quite small with most currency pairs moving about one cent per day.  The high leverage levels and extreme liquidity is what makes this market so attractive to traders.

Economic Theories Related to Foreign Exchange Trading

Academic economic theories abound when it comes to the currency market.  Whilst these may not be applicable to normal daily trading, it will not hurt you to know these theories.  The main theory found in foreign exchange trading deals with parity conditions.

Purchasing Power Parity

This theory states that the price levels of goods between two countries should theoretically be equal after adjustments have been made for the exchange rate.  This is based on the law of one price which states that an identical item should cost the same globally.  If the price variance, after the exchange rate adjustment, is large, an arbitrage opportunity will be creased as the item can be obtained from the one that offers it at the lowest price.  An example to illustrate is if the inflation rate in country A is 10%, and the rate in country Z is 5%, then country Z’s domestic currency should be increased by 5% against country A’s.

Interest Rate Parity

This concept is similar to PPP in that the suggestion is that to eliminate arbitrage opportunities, the same assets in two different countries should carry the same interest rates, provided the risk is the same for each.  The basis for this theory is the same as in PPP.

Balance of Payments

The balance of payments of a country is made up of two segments, namely, the capital account and the current account.  This measures the capital for a country and the inflow and outflow of goods.  The balance of payments theory uses the current account as its basis.  This is the account which deals with the trading of tangible goods.

The theory states that if a country has a big current account deficit or surplus, it is indicative of an out of balance exchange rate.  To balance the current account, it will be necessary for the exchange rate to be adjusted over time.  If a country is experiencing a large deficit which indicates fewer exports and more imports, the currency will decline.  By the same token, a surplus in this calculation will cause an increase in the currency value.

The identity of the balance of payments is calculated thus:

  • Current account balance + capital account balance + reserves account balance = 0

Real Interest Rate Differentiation

This model suggests that countries experiencing higher real interest rates will notice an increase in their currency against that of countries that have lower interest rates.  The main reason for this can be attributed to the fact that global investors will invest their money in the countries with higher rates in order for them to earn higher returns on their investment.

 

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