Forex trading is the buying and selling of different currencies. Fundamental analysis is a type of market analysis that involves taking a keen study on the economic situation of the different currencies on the forex chart and interpreting the statistics from the analysis in order to trade effectively.

It also involves reviewing the future of the forex market of different currencies by looking at different factors like economic, political, and social factors.

These factors help people learn forex trading and make informed decisions on when and how to trade currencies.

The most important indicator that a trader must look into is the economic situation of the different countries whose currencies are being traded.

The economic condition of a country often has the greatest impact on the value of money of any given nation.

A trader who happens to analyse the fundamental condition of a currency must also not forget to look into the interest rates and any indicators of inflation in the various countries.

A trader’s best friend when analysing the forex market is an economic calendar. Economic calendars, also known as financial calendars, act as a financial watch to keep track of all the economic happenings.

It is often timely and most of the time accurate. These financial calendars can either be found from central banks or from some brokers.

Because most economic indicators have a great impact on online forex trading, it is important for every trader to be observant and follow keenly the changes that may occur on the economic calendar.

Every trader is therefore advised to have a good grasp of fundamental analysis in forex trading as this will help him or her know how to make profitable trade decisions.

There are several things that a trader should look into during the process of analysing the forex market.

These are also known as the most powerful figures that move the forex market.

1. Purchasing Power Parity

Commonly known as PPP by many economists, purchasing power parity is a theory in the economic world that is based on the assumption that the exchange rates between two given countries should be the same as their purchasing power.

In order to achieve purchasing power parity, the theory looks into the example of inflation.

According to this theory, when a country experiences inflation, its exchange rate must also depreciate so as to achieve the purchasing parity.

Purchasing power parity can also be said to be the estimate of how a country needs to adjust its exchange rates in order to fit or match another country’s currency purchasing power.

In simpler terms, purchasing power parity can be defined as a technique used to determine the adjustment that one country needs on its exchange rate so that another country when trading their currency may have the same value when put in their own currency.

Purchasing Power Parity can also be said to be a policy that requires international rates to be balanced according to the cost of goods and services in given countries.

For instance, when a bar of chocolate costs 1.50 Canadian Dollars in a Canadian City, the same bar of chocolate should cost 1US Dollar in an American City when the exchange rate between the two countries is 1.50 USD/CAD. Purchasing power parity or PPP is calculated as:

S = P₁/P₂

Where S represents the exchange rate of currency 1 to currency 2, P₁ represents the cost of goods in currency 1 and P₂ represents the cost of goods in currency 2.

Forex purchasing power parity can also be expressed as the existence of equality of the different currencies that are trading when their purchasing power is the same in their country.

The purchasing power parity is actually the shortest way of calculating the cost of living in different countries and helps any forex trader know how to trade with the different countries.

Purchasing power parity was developed in 1920 by one Gustav Cassel and was based on the law of one price, which assumes that in every market, identical goods should have the same price despite the country in which that good is.

Purchasing power parity is therefore very important to every forex trader because it is the major driving factor in the movement of foreign currencies in the forex market.

Purchasing power parity can be successfully used in online currency trading because it is a long term fundamental indicator that can be used to predict the future of a currency price for up to 2 years or more.

PPP is generally a leading influencing factor especially when it comes to creating long term goals in forex trading.

2. Interest Rate Parity

Interest rate parity or IRP plays a very important role in the forex trading market by connecting interest rates, spot exchange rates, and future exchange rates.

Interest rate parity can be described as a theory that is used to determine the relationship that might be present between the spot exchange rate and the future exchange rate of currencies.

Spot exchange rate is the exchange rate at which two parties agree to trade at the moment.

Interest rate parity can also be used to determine whether the difference between interest rates of two given countries is equal to the difference between the future exchange rate and the spot exchange rates of the countries in question.

There are different kinds of interest rate parity:

(a) Covered Interest Rate Parity

Covered interest rate parity is a situation whereby the interest rates and the currency values of two currencies are equal.

When this condition occurs, it means that there is no advantage to borrow one currency in order to purchase the other and also there is no opportunity for the two currencies to trade.

When there is covered interest rate parity, an investor cannot earn arbitrage profit because the interest differences between two given currencies have been offset by their spot and future exchange currency differences.

Arbitrage profit means the kind of gains that an investor gets by exploiting different prices of similar goods and services.

(b) Uncovered Interest Rate Parity

Uncovered interest rate parity is a condition that states that there is always an opportunity to make profit when the interest rates of two given countries, say America and Canada, are equal to any change that is expected in the exchange rates between the currencies of the  two countries.

The opportunity to make profit only occurs when the above parity does not exist. The uncovered interest rate parity can be explained as:

Where:

“i₁” represents the interest rate of country 1
“i₂” represents the interest rate of country 2
“E(e)” represents the expected rate of change in the exchange rate

(C) Balance of Payment

Balance of payment or BoP is a method that different countries use to obtain a record of all their monetary transactions with other countries within a given period of time.

Balance of payment is calculated differently by different countries, though most countries do it every 4 months or every 6 months while other countries prefer to do it on an annual basis.

The balance of payment often summarizes the total usage of money in a given country and is usually prepared in a single currency, preferably the currency of the country preparing it.

Some of the matters that are considered when preparing a balance of payment include all the trades conducted by both private and public sectors, the sources of finances for the given nation for instance loans, grants, and exports, and how the country uses its funds for instance to import goods and services, investments etc.

It is important to note that when a country borrows money, it is recorded as credit but when it pays back the borrowed money or when it gives out money somewhere, it is recorded as debit.

At the end of the day, these two columns must balance but that is often a rare case.

When the balance of payment is prepared, there is always either a negative or a positive balance. When the balance is negative, it means the country is in a deficit.

There is more money going out than what is coming in and when the balance is positive, it means the country is in surplus; that is, there is more money coming in probably from foreign investments and exports than the actual spending.

The balance of payment is one way a country can use to gauge both its political and economic stability.

Balance of payment also measures a country’s value in their currency because while calculating the BoP, trade balance, foreign investments and investments within the country by foreigners are also considered.

Therefore, if a country has a consistent positive balance of payment, it only means that the economy of that given country is stable.

Since balance of payment is a concept that simply compares the international relations that countries have between each other, to compute it you simply have to know the difference in the exports and imports.

You first have to determine the amount of exports that a given country has against the amount of imports. Once you find the difference that will be your balance of payment.

When the balance of payment is positive, that means the country has a surplus and there is more money flowing in than out.

When the balance of payment is in the negative, it means the country is in deficit and the amount of money flowing out is more than what is flowing in.

The calculation is shown as thus:

S = P₁ – P₂

Where S is the balance of payment

P1 is the total amount of imports

P2 is the total amount of exports

Economic interdependence of different countries increases by the day and that is why most countries have resorted to trading forex.

One of the factors that has influenced the trading of forex between countries is the balance of payment.

When the balance of payment is in the negative, it means the country is in deficit, and this directly reflects on its exchange rate and many investors will not want to trade with such a country because of its economic instability.

But when the balance of payment is positive, the country has a surplus and this will attract more investors because the interest rates together with the exchange rates will be favourable for investments.

Different currencies are often traded in the forex market with the prices of these currencies rising and falling as the changes in demand and supply come and go. A change in the demand and supply of one currency is directly affected by the change in demand and supply of another currency in the forex market. A change of preference for a particular good or service also affects its supply and demand and the same also applies to currency exchange. When an investor is no longer interested in trading a particular currency, the demand for that currency falls and the supply will therefore fall too. This has a direct impact on the balance of payment that will be prepared later.

3. Common Economic Indicators

An economic indicator can be defined as a statistics about the economy that allows an investor to analyse the trend of the forex market and make profitable trade decisions.

There are thousands of economic indicators that are released into the forex market every now and then.

And, in the earlier years, only the economists and professional and experienced forex traders would get a hold of these indicators early enough.

Thanks to the emergence of the internet, these days any one can access these indicators the moment they come up.

Economic indicators are known to have a very huge impact on the forex market and it is therefore important for every forex trader, whether experienced or amateur, to know how to interpret and analyze them.

It does not help to have indicators and yet fail to know how to interpret them.

Every forex investor must therefore know where to find these economic indicators, how to interpret them, and how to analyze them in order to know the road the economy is taking and whether your investment in the forex market is worth the risk.

An economic indicator can also assist to predict future performance of the forex market and help them make long-term investment strategies.

These economic indicators are usually long and big in volume. They are often produced by government agencies, non-profit organizations and in some other times, private companies also produce them.

Most of these indicators are produced daily, weekly, and monthly with rare quarterly and annual basis.

There are several common economic indicators that investors must ensure they know about if they want to look into making it big in currency trading.

Here is a discussion of some few of them:

(a) Gross Domestic Product (GDP)

The gross domestic product or GDP is one of the major ways used to determine the stability of an economy of a given country.

It is a direct representation of the value of all the different goods and services belonging to a particular country.

It can also be said to be the total value of money from of all the goods and services produced within the borders of a given country within a specified period of time.

The gross domestic product of a country is often compared to the previous year or a given time period.

When the GDP is said to have gone up with a given percentage, say 5%, in simple terms means that the economy of that given country shot up by 5% and when the GDP falls by 5%, it means the economy has dropped by 5%.

Calculation of gross domestic product includes public and private sectors, investments, and exports as long as they happen within the borders of the country in question.

Calculating gross domestic product is often complicated but it can be done in one of two ways: either by adding up what everyone has earned in a year also known as income approach or by adding up what everyone has spent within that year also known as the expenditure method.

Both of these approaches should be able to get you roughly the same figure. The income approach involves getting the total wages and salaries to employees, gross profits for firms, and taxes.

The expenditure method, however, which is the most commonly used form of calculating GDP, is arrived at by adding up the total consumption, investment, government spending and net exports.

An important tip and trick is that apart from using gross domestic product as a way of gauging the stability if an economy, it is also used to measure the standard of living of the people within a country.

When the GDP is always rising, there is a high probability for foreign investors to come into the country and invest thus improving the country’s economy through foreign exchange. The gross domestic product is measured as thus:

GDP = C + G + I + NX

where:

C is equal to all private consumption, or consumer spending, in a nation’s economy
G is the sum of government spending
I is the sum of all the country’s businesses spending on capital
NX is the nation’s total net exports, calculated as total exports minus total imports. (NX = Exports – Imports)

 

(b) Employment Situation

The employment situation of a country is also another economic indicator that investors use to gauge the strength of the economy of a given country before deciding to invest there.

To get the labor report a country, an establishment survey that involves sampling various businesses and investments within the country is usually done.

The other survey is known as the house hold survey and it involves the collection of data from various households within the country and it represents the total number of citizens who are unemployed/jobless, the total number of people who are working/employed/self employed, and their average annual salary and also the number of hours an individual works per day.

The findings of both surveys are then used to come up with the employment situation of the country and released to the public.

The employment situation of every country is one of the major indicators that investors look into.

They always take a keen look at the labor report and study it closely to learn about the trends of income, wage inflation, and employment statistics.

Some investors even take a keen look at the companies that they are interested in.

When the investors notice a rise in the salaries and wages of the workers, they get convinced that the economy is rising at a stable rate and will therefore decide to invest in such economies.

Labor reports may not necessarily define an economy but at least it gives an investor a clear picture of what the economy of a given country is like.

The employment rates indicate the well being of the people in the society and the economy as well. The average number of hours worked and also the average pay per hour shows how the labor market is.

When the labor market is too tight; that is, when there are too many employees in a given company, there will be a case of wage inflation such that every employee will get meager wages in a bid to cater for everyone in the company.

This does not portray a positive picture especially to the investor who is going through the labor report.

The labor report being the most widely read report across the world receives more air time in the media and this gives it the ability to move the forex markets as well. The employment situation is one of the indicators that investors look into.

These employment situation reports also tend to relate to the investors on a personal level as every investor gets a clear understanding of the kind of market they are looking to get into.

Summary

Fundamental analysis in online forex trading is a major strategy that every investor must understand before deciding to invest in the currency market.

It is important for investors to learn about the trends of the different economies when taking part in the business of trading currencies.

To know more about the different economies, they should learn to read and interpret the various economic indicators such as the Gross Domestic Product reports and the labor reports.

Some other factors that should help investors conduct a reliable fundamental analysis include purchasing power parity and interest rate parity.

And, if done correctly, fundamental analysis can be of much help in identifying profitable trading opportunities in the foreign exchange market.