What is Forex?
Forex (also shortened as FX) refers to the foreign exchange market in which the foreign currencies of the world are traded.
The forex market, also called the currency market, is an electronic network of participants, like governments, banks, institutions, brokers, and individual traders, who in general trade through forex brokers or banks.
Fundamental analysis in the business world
Fundamental analysis (FA) is a method of determining a stock’s real value (intrinsic value) by looking at a company or business at a fundamental level.
This type of analysis examines key ratios of a business to ascertain its financial health and the effectiveness of its management. Key ratios examined are, inter alia:
- Earnings per share (EPS) is an indication of how much of a company’s profit is assigned to each share.
- Price-to-earnings ratio (P/E) compares a company’s per-share earnings to its current sales price of stock.
- Return on equity (ROE) is calculated by dividing the company’s net income by shareholders’ equity. It is also referred to as return on net worth.
The final objective of the fundamental analysis of a company is to determine whether its stock is undervalued or overvalued.
What is fundamental analysis for forex?
Among others, the word fundamental describes facts, indicators, and principles that are essential and particularly important. They form the foundation from which decisions and activities develop.
The core element of fundamental analysis in the business world is to determine the intrinsic value of an investment. Applied to forex, FA implies scrutinizing the economic conditions that affect the valuation of a country’s currency.
The thought behind fundamental analysis for forex is that if a country’s current or future economic picture is strong, its currency should strengthen and vice versa.
The healthier a country’s economy is, the more businesses and investors from other countries will invest in that country. This results in a bigger demand for that country’s currency.
In forex fundamental analysis, fundamental indicators are used as a foundation to determine the financial value of a country’s currency. Investors and analysts study and scrutinize the relevant fundamental indicators to validate the fair valuation of a currency.
Some especially important fundamental indicators pertaining to fundamental analyses for forex are:
- Gross domestic product (GDP).
GDP is seen as one of the best fundamental indicators of a country’s economy.
Gross domestic product measures the total value of all services and goods produced in a country within a given time frame, usually a quarter of a year. The economic logic behind this is that an increase in GDP must be followed by an increased demand for services and goods.
The growth rate of GDP is an important indicator to look for.
Inflation indicates the rate at which the general level of the prices for goods and services is rising in a country. Conversely, it denotes the falling purchasing power of a currency.
Inflation is also an important forex fundamental indicator as it is an indication of the healthiness of a country’s economy.
Regarding forex trading, the higher the inflation rate, the quicker the depreciation of the currency, with the result that it becomes a less reliable asset for foreign investors.
Inflation is measured by the Consumer Price Index (CPI) that measures the percentage change in the price of a bundle of consumer goods and services from month to month and the Producer Price Index (PPI) that measures the average changes in prices received by domestic producers for their output.
- Interest rates
Interest rates are the value charged by central banks for lending money to private banks and are a key tool to control inflation.
In professionally managed and balanced economies, raising interest rates by central banks may be needed to cut the pace of money lending and to calm down economies by reducing inflation.
On the contrary, if there is a shortage of money in circulation, and a government wants to stimulate the economy, a central bank will cut interest rates, making it less expensive and easier for businesses and individuals to borrow money.
Interest rates are the major fundamental indicator for a forex trader since generally, an increase in interest rates moves a currency to appreciate, as there is a cut in supply.
On the contrary, with the decreasing of interest rates, the demand for borrowing increases, and the currency depreciates.
Regarding the supply and demand of a currency, central banks only regulate the supply of currencies, while demand for it is initiated by political and economic stability, as well as the willingness of investors to use the currency as a predictable and reliable financial asset.
In stable and healthy economies, high-interest rates attract investors, while high-interest rates accompanied by hyperinflation attracts only speculators.
A nominal interest rate is a rate before taking inflation into account, while a real interest rate is a rate after allowing for inflation.
Other fundamental indicators with regard to fundamental analyses for forex
Some other indicators to guide a trader in fundamental analyses for forex are:
- Political and social events.
- How a currency will react to macro-economic events.
- Monetary policy of central banks.
- Employment reports, including the unemployment rate.
- Trade balance – the difference between a country’s imports and exports.
Advantages and disadvantages of fundamental analysis
Advantages
Fundamental analysis helps traders to understand market dynamics and the drivers of a country’s economy, in order to acquire confidence and composure to hold out against market volatility.
It provides wide-ranging insight into global market conditions. The longer the time frame of trading, the more accurate fundamental analysis generally becomes.
FA assists a trader to acquire and keep a long-term view of a particular currency pair.
Disadvantages
Fundamental analysis can be subjective. It does not eliminate all the emotions from a decision.
It can also be both times consuming and difficult to understand.
It is not well-suited for short term trading.
A trader can suffer from an overload of information. Fundamental analysis is a broad and deep subject. All the information available can be overwhelming. This can sometimes lead to confusion and result in being counterproductive at times.
What is technical analysis?
In short, technical analysis (TA) in forex is the framework in which forex traders examine previous price movements. The fundamental premise of TA is that a trader can look at historical price movements and determine the current trading conditions and potential future price movement.
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