Within the Forex market, those who engage in fundamental analysis evaluate currencies and the countries from which they hail and use economic announcements to determine the true value of a currency. This form of analysis is different from technical analysis, which predicts future price movement based on historical price movement. Fundamental traders in the Forex market look at currencies and countries similar to how fundamental analysts in the equities market view companies.
As they are with stock, political events, economic data, and news reports are issued about a company. Investors use this information to figure the value of the country’s currency. Value changes over time and is influenced by factors like financial strength and economic growth. This information is taken into account by fundamental traders when they are evaluating the currency of a country.
The number of fundamentals trading strategies in the Forex market are almost limitless. One of the most well-known is the Forex carry trade. This is a strategy involving the sale of a currency that features a low interest rate and purchase of a currency that has a higher interest rate. In essence, investors are borrowing at a low interest rate and lending at a higher interest rate. By doing so, the trader realizes the difference between these two rates and the higher currency’s value may rise as money flows into it.
A real-world example is that of the Japanese yen. In 1999, Japan decreased interest rates to close to zero. Investors seeking to capitalize on this borrowed a large amount of yen. These yen were converted to U.S. dollars and used to purchase U.S. Treasury bonds featuring coupons and yields between 4.5 and 5 percent. The result was that investors were paying nearly nothing to borrow the yen and earning almost the entire Treasury bond yield.
Using leverage, the return on such a transaction could be multiplied. To clarify, a ten times leverage situation would result in a 50% return on a five percent yield. An individual with $1,000 in an account who has access to ten times leverage will in essence control $10,000. Using the carry trade example above, the person would earn five percent per year, turning a $10,000 investment into $10,500, a gain of $500. Since only $1,000 of the trader’s money was invested, the real return would be $500 divided by $1,000, or 50 percent.
A fundamental analysis strategy like this will only work if the value of the currency pair appreciates or remains unchanged. This leads most carry traders to look at capital appreciation in addition to the difference in interest rates. The primary lesson to learn from this example is that small differences in interest rates can lead to large gains when leverage is used.
Fundamental analysis involves understanding that a country and its currency are constantly changing in terms of value. These changes are based on factors like interest rates and economic growth. Prior to participating in the market, fundamental analysts should understand how the currency of a country is affected by these factors.