Two types of analysis are used for market movements
forecasting: fundamental, and technical (the chart study of past behavior of
currencies prices). The fundamental one focuses on theoretical models of
exchange rate determination and on major economic factors and their likelihood
of affecting foreign exchange rates.
Theories of exchange rate determination
Purchasing power parity states that the price of a good in
one country should equal the price of the same good in another country,
exchanged at the current rate—the law of one price. There are two versions of
the purchasing power parity theory: the absolute version and the relative
version. Under the absolute version, the exchange rate simply equals the ratio
of the two countries' general price levels, which is the weighted average of
all goods produced in a country. However, this version works only if it is
possible to find two countries, which produce or consume the same goods.
Moreover, the absolute version assumes that transportation costs and trade
barriers are insignificant. In reality, transportation costs are significant
and dissimilar around the world. Trade barriers are still alive and well,
sometimes obvious and sometimes hidden, and they influence costs and goods
distribution. Finally, this version disregards the importance of brand names.
For example, cars are chosen not only based on the best price for the same type
of car, but also on the basis of the name ("You are what you drive").
Under the PPP relative version, the percentage change in the
exchange rate from a given base period must equal the difference between the
percentage change in the domestic price level and the percentage change in the
foreign price level. The relative version of the PPP is also not free of
problems: it is difficult or arbitrary to define the base period, trade
restrictions remain a real and thorny issue, just as with the absolute version,
different price index weighting and the inclusion of different products in the
indexes make the comparison difficult and in the long term, countries' internal
price ratios may change, causing the exchange rate to move away from the
relative PPP. In conclusion, the spot exchange rate moves independently of
relative domestic and foreign prices. In the short run, the exchange rate is
influenced by financial and not by commodity market conditions.
Theory of elasticities holds that the exchange rate is
simply the price of foreign exchange that maintains the balance of payments in
equilibrium. In other words, the degree to which the exchange rate responds to
a change in the trade balance depends entirely on the elasticity of demand to a
change in price. For instance, if the imports of country A are strong, then the
trade balance is weak. Consequently, the exchange rate rises, leading to the
growth of country A's exports, and triggers in turn a rise in its domestic
income, along with a decrease in its foreign income. Whereas a rise in the
domestic income (in country A) will trigger an increase in the domestic
consumption of both domestic and foreign goods and, therefore, more demand for
foreign currencies, a decrease in the foreign income (in country B) will
trigger a decrease in the domestic consumption of both country B's domestic and
foreign goods, and therefore less demand for its own currency. The elasticities
approach is not problem-free because in the short term the exchange rate is
more inelastic than it is in the long term and additional exchange rate
variables arise continuously, changing the rules of the game.
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