The two primary approaches of analyzing currency markets are fundamental analysis and technical analysis. Fundamentals focus on financial and economic theories, as well as political developments to determine forces of supply and demand. One clear point of distinction between fundamentals and technical’s is that fundamental analysis studies the causes of forex market movements, while technical analysis studies the effects of market movements.Purchasing Power Parity
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.
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 when prices eventually correct towards parity.
Interest Rate Parity
IRP states that an appreciation of one currency trading 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 risk less 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.
Asset Market Model
The explosion in forex trading of financial assets 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.