While forex rates trading involves a large amount of economic theory, it is not always applicable to daily trading. However, it is important to understand the theory, as it can help with profitable trading.
The Fisher Effect
The theory states that two countries’ forex rates should vary by an amount which is the same as the variance between the countries’ nominal interest rates. In the event that one country shows a lower rate than another, the one with the lower rate’s currency should increase by the same amount when compared with the country with the higher rate.
The balance of payments theory
The balance of payments of a country is made up of two sections – its capital account and its current account. These segments are the measurement of the in and outflows of capital and goods in a country. The current account is the account that deals with the trade involving tangible goods. The balance of payments theory looks at this account to obtain a fair idea of the direction of forex rates.
In the event that the country is running a large deficit or surplus in their current account, it is indicative of an out of balance exchange rate. To bring this back into balance, it is necessary for the exchange rate to be adjusted over time. If there is a huge deficit, it implies that there have been fewer exports than imports. This will cause the domestic currency to decline. If there is a surplus, the currency will appreciate.
Forex rates and the parity theory
One of the chief economic theories found in forex deals with conditions of parity. This is an economic explanation regarding the price at which one currency should be traded for another. This theory is based on certain factors like interest rates and inflation. The theory states that when there is no parity, an opportunity to trade becomes available to the participants in the market. Trading opportunities are normally very quickly recognised in other markets and quickly eliminated before an individual investor is able to capitalise on it.
Other economic theories are based on factors such as capital flows, the manner in which a country trades and operates, and trade factors.
The purchasing power parity theory
This is an economic theory which states that the price levels that exist between one country and another should be equal once the exchange rate has been adjusted. It is based on the law of one price where it states that the cost of the same item should be the same globally. This theory states that if a large variance in price exists between any two countries for the same item, after the adjustment made for the exchange rate, a trading opportunity will be created. This is due to the fact that the product can be purchased from the country that is selling it at the lower cost.
The interest rates parity power
This economic concept is very similar to purchasing power parity. It states that to eliminate any trading opportunities, similar assets in two countries should carry similar interest rates. This should be so provided the risk for each asset is the same. This parity is also based on the law of one price. It states that buying an investment asset in a country should give you the same return if you held the same asset in a second country. If not, the exchange rates would have to be adjusted to account for the variance.
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