In the equities market, fundamental analysis looks to measure a company's true value and to base investments upon this type of calculation. To some extent, the same is done in the retail forex market, where forex fundamental traders evaluate currencies, and their countries, like companies and use economic announcements to gain an idea of the currency's true value.
All of the news reports, economic data and political events that come out about a country are similar to news that comes out about a stock in that it is used by investors to gain an idea of value. This value changes over time due to many factors, including economic growth and financial strength. Fundamental traders look at all of this information to evaluate a country's currency.
Given that there are practically unlimited forex fundamentals trading strategies based on fundamental data, one could write a book on this subject. To give you a better idea of a tangible trading opportunity, let's go over one of the most well-known situations, the forex carry trade. (To read some frequently asked questions about currency trading, see Common Questions About Currency Trading.)
A Breakdown of the Forex Carry Trade
The currency carry trade is a strategy in which a trader sells a currency that is offering lower interest rates and purchases a currency that offers a higher interest rate. In other words, you borrow at a low rate, and then lend at a higher rate. The trader using the strategy captures the difference between the two rates. When highly leveraging the trade, even a small difference between two rates can make the trade highly profitable. Along with capturing the rate difference, investors also will often see the value of the higher currency rise as money flows into the higher-yielding currency, which bids up its value.
Real-life examples of a yen carry trade can be found starting in 1999, when Japan decreased its interest rates to almost zero. Investors would capitalize upon these lower interest rates and borrow a large sum of Japanese yen. The borrowed yen is then converted into U.S. dollars, which are used to buy U.S. Treasury bonds with yields and coupons at around 4.5-5%. Since the Japanese interest rate was essentially zero, the investor would be paying next to nothing to borrow the Japanese yen and earn almost all the yield on his or her U.S. Treasury bonds. But with leverage, you can greatly increase the return.
For example, 10 times leverage would create a return of 30% on a 3% yield. If you have $1,000 in your account and have access to 10 times leverage, you will control $10,000. If you implement the currency carry trade from the example above, you will earn 3% per year. At the end of the year, your $10,000 investment would equal $10,300, or a $300 gain. Because you only invested $1,000 of your own money, your real return would be 30% ($300/$1,000). However this strategy only works if the currency pair's value remains unchanged or appreciates. Therefore, most forex carry traders look not only to earn the interest rate differential, but also capital appreciation. While we've greatly simplified this transaction, the key thing to remember here is that a small difference in interest rates can result in huge gains when leverage is applied. Most currency brokers require a minimum margin to earn interest for carry trades.
However, this transaction is complicated by changes to the exchange rate between the two countries. If the lower-yielding currency appreciates against the higher-yielding currency, the gain earned between the two yields could be eliminated. The major reason that this can happen is that the risks of the higher-yielding currency are too much for investors, so they choose to invest in the lower-yielding, safer currency. Because carry trades are longer term in nature, they are susceptible to a variety of changes over time, such as rising rates in the lower-yielding currency, which attracts more investors and can lead to currency appreciation, diminishing the returns of the carry trade. This makes the future direction of the currency pair just as important as the interest rate differential itself. (To read more about currency pairs, see Using Currency Correlations To Your Advantage, Making Sense Of The Euro/Swiss Franc Relationship and Forces Behind Exchange Rates.)
To clarify this further, imagine that the interest rate in the U.S. was 5%, while the same interest rate in Russia was 10%, providing a carry trade opportunity for traders to short the U.S. dollar and to long the Russian ruble. Assume the trader borrows $1,000 US at 5% for a year and converts it into Russian rubles at a rate of 25 USD/RUB (25,000 rubles), investing the proceeds for a year. Assuming no currency changes, the 25,000 rubles grows to 27,500 and, if converted back to U.S. dollars, will be worth $1,100 US. But because the trader borrowed $1,000 US at 5%, he or she owes $1,050 US, making the net proceeds of the trade only $50.
However, imagine that there was another crisis in Russia, such as the one that was seen in 1998 when the Russian government defaulted on its debt and there was large currency devaluation in Russia as market participants sold off their Russian currency positions. If, at the end of the year the exchange rate was 50 USD/RUB, your 27,500 rubles would now convert into only $550 US (27,500 RUB x 0.02 RUB/USD). Because the trader owes $1,050 US, he or she will have lost a significant percentage of the original investment on this carry trade because of the currency's fluctuation - even though the interest rates in Russia were higher than the U.S.
Another good example of forex fundamental analysis is based on commodity prices.
You should now have an idea of some of the basic economic and fundamental ideas that underlie the forex and impact the movement of currencies. The most important thing that should be taken away from this section is that currencies and countries, like companies, are constantly changing in value based on fundamental factors such as economic growth and interest rates. You should also, based on the economic theories mentioned above, have an idea how certain economic factors impact a country's currency. We will now move on to technical analysis, the other school of analysis that can be used to pick trades in the forex market.