Currency Analysis

If we have a look at forex ads in the newspaper, there are many misleading advertisements that say that you don’t need to know anything about economics or the fundamentals of the foreign exchange market to be successful in forex. Obviously the contribution of economics to the field of currency analysis plays a huge role, especially in equilibrium exchange rate models, an important tool for analyzing long-term exchange rate trends where they basically give you the big picture of the foreign exchange market.

However, as the currency market is affected by so many different factors, it is an impossible task for economists to design fundamental equilibrium models with predictive capacity for anything other than the long term. Hence, there’s a need to look beyond the theoretical models, where flow and technical analysis have succeeded to a far greater degree than equilibrium exchange rate models in predicting short-term exchange rate moves.

So in general, we can classify the 2 different techniques in predicting exchange rates to fundamental and technical analysis. I’ll try to expand more on the different forms of analysis and hopefully you’ll be able to learn something useful from it.

Fundamental Analysis

Traditional Exchange Rate Models

Traditional exchange rate models are based on several important assumptions, that:

• Markets are essentially rational
• Information is available to everyone at all times
• Divergence from fundamental equilibrium levels will eventually be eliminated.

Derived from the relative pricing of a given commodity and since an exchange rate is made up of 2 currencies, traditional exchange rate models reflect the relative pricing of a commodity between the 2 countries concerned:

It has been said that the foreign exchange market is very different from other financial markets such as the equity or fixed income markets due to the majority of forex traders being speculators, which may explain why in general, the traditional exchange rate models are poor predictors of exchange rates over the short term.

Also, there’s a myth that there is perfect knowledge dispersal in the forex market and thus there should exist no knowledge advantage by any participants. This is largely untrue simply because the amount of information affecting exchange rates is so huge that not everyone without the right tools can absorb and analyze them all the time.

Not departing far from the traditional exchange rate models, there are a few analytical tools which are used by many forex traders in bridging the gap between the short-term and long-term exchange rate fundamental analysis:

• Standard Accounting Identity for Economic Adjustment
• J-Curve
• Real Effective Exchange Rate (REER)

Flow Analysis

Traditionalists among the economists frequently think that economics was the “cause” and capital flow the “effect”. However, there have been debates about how capital flow can be both the “cause” and “effect” in its relationship with economics, which brings the idea that information about actual currency transactions and orders to be transacted (order flow) not only explains exchange rate movements but also helpful in forecasting future exchange rate moves.

Over the past few years, capital flows are getting larger and move more easily due to globalization. Shifts in private capital flows can happen in absence of major changes in economic information as a result of changes in investor risk tolerance, liquidity, portfolio balancing needs, hedging needs and so on. Therefore, flow models essentially track the sum of client orders and transactions, comparing them to exchange rate prices in real-time and check for any correlations.

So far, most flow models out there are created by a large number of commercial and investment banks and the models are getting more and more sophisticated. These proprietary flow models track the foreign exchange activity of their global client base such as the CitiFX Flows advisory service.

Technical Analysis

Whereas flow analysis focuses on price trends that are created by order flow, technical analysis focuses on price patterns within those trends. Technical analysis is the process of analyzing a currency’s historical price to predict its future price direction, founded in the belief that consistent patterns within price actions exists and thus have predictable results in future.

Technical analysis works because customer orders normally are around a certain price level which represents the consensus of market supply and demand. Below the price, there should be “support” levels at which demand is expected to exceed supply and above the price, there should be “resistance” levels at which supply exceeds demand.

Analyzing these price trends resulted in tools such as the candlestick chart, moving average, relative strength index (RSI), moving average convergence divergence (MACD) and more. Technical analysts and traders look at price patterns differently and thus over the years, a few school of thoughts have resulted such as the Fibonacci, Elliott Wave Theory and Gann Theory.

There is simply too much to explain in just a one page, but I’ll try to do my best in explaining all the different methods in currency analysis over the next few articles.

This entry was posted on Tuesday, October 17th, 2006 at 3:46 pm and is filed under Technicals, Fundamentals, Theory. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.