The economic theories that forex trading is based on may not always apply to your everyday trading, but they will help you understand the reasons for movements in foreign exchange rates.
This is one of the main economic theories that you will experience in foreign exchange deals. It is an economic explanation about the price at which one currency should trade against another. The theory is based on particular factors, such as inflation and interest rates. It is based on the fact that if there is no parity, a trading opportunity is made available to market participants. In other market, trading opportunities are often quickly recognised and eliminated before individual investors are allowed to capitalise on those opportunities.
Other theories are based on factors that include the way in which countries operate and trade, trade factors and capital flows.
Interest Rate Parity
This is a similar concept to purchasing power parity. The theory states that similar assets in different countries should have similar interest rates as this will eliminate the trading opportunity that may exist. This parity should exist provided the asset risk is the same in the different countries. This theory is also based on the law of one price. The law state that you should obtain the same return on investment in different countries. If this is not possible, the foreign exchange rates would have to be adjusted to account for the difference.
Purchasing Power Parity
This theory states that price levels between one country and another should be on par after an adjustment has been made for the foreign exchange rates. The theory is based on the law of one price which states that the same item should cost the same in all countries. It states that if there is a large disparity between prices in different countries once an adjustment for the exchange rate has been made, it creates a trading opportunity. This is because the item can be bought from a country with a lower item cost and sold at a higher price elsewhere.
Balance of Payments
A country’s balance of payments is made up of its current and its capital account. The categories contain the measurement of the inflows and outflows of goods and capital within a country. The trade of tangible goods is shown in the current account. The theory based on balance of payments considers this account when it looks at the direction forex rates may move in.
If a country is experiencing a surplus or a deficit in this current account, it means that its exchange rate is out of balance. To return it to equilibrium, the exchange rate will have to be adjusted over a certain period of time. In the case of a massive deficit, it shows that the country’s export levels have fallen below its import levels. This will eventually cause a decline in the currency rate. In the case of a surplus, the country’s currency value will increase.
Fisher Effect on Foreign Exchange Rates
This theory states that exchange rates between countries should differ by the same amount as the difference in the countries’ nominal interest rates. If one country’s interest rate is lower than another’s, the rate of the lower country should be increased by the difference in rates.
Knowing about and understanding the theories behind the determination of foreign exchange rates can aid you in a suitable prediction of currency values.