Introduction to fundamental analysis
Fundamental analysis, when referring to forex, involves studying the economy of a country to determine the effect this has on the value of its currency. Understanding the relationship between an economy and its currency value can allow a trader to determine, to a degree, the demand and a likely increase/decrease in value for a particular currency.
This can give a trader an advantage, because they can determine whether a currency pair is likely to rise or fall. We explain this in more detail throughout this lesson.
Economic indicators can be used to evaluate an economy
There are certain economic indicators, or reports, that forex traders can observe in order to determine the strength of an economy. These reports are released by governments and independent bodies who collect and analyse the data prior to publishing it. They are released at set times and can be released weekly, monthly, quarterly or annually, depending on the report.
Traders will generally look at the latest result of each report, as well as any changes to the results from the last published report.
Economic reports and news will affect the currency value
A strong economy is more likely to present opportunities for business, such as returns on real estate, the stock market or other business ventures.
If an economic report therefore shows that an economy is strong, then domestic and foreign investors – private or corporate – may seek investment opportunities in that country.
In order to invest capital into a country, an investor will need to do this in the local currency. So if it is perceived that an economy will produce great returns for investment, then the local currency will be more in demand and hence the currency value is likely to appreciate.
Economic reports and news will affect the currency value
A strong economy is more likely to present opportunities for business, such as returns on real estate, the stock market or other business ventures.
If an economic report therefore shows that an economy is strong, then domestic and foreign investors – private or corporate – may seek investment opportunities in that country.
In order to invest capital into a country, an investor will need to do this in the local currency. So if it is perceived that an economy will produce great returns for investment, then the local currency will be more in demand and hence the currency value is likely to appreciate.
Exporting goods and services affects a currency value
If an economy is strong in a particular sector, for example in manufacturing or financial services, then they are likely to export those manufactured goods or financial services abroad.
Customers that are purchasing these goods and services will have to convert their domestic currency to the local currency of the producer. The more demand there is for these goods and services, the higher the demand for the local currency and so the value of it appreciates.
Financial markets react to news
When economic reports are released, there is a certain amount of speculation on what the results may be. Forex traders buy or sell currencies in anticipation of this. For example, if the results of an economic report are expected to be negative, then traders tend to sell the currency in question ahead of the report's release, causing the price to fall.
When this happens, the markets are referred to as being ‘priced in’ – meaning that by the time the event has taken place, the price has already changed as expected.
When the data is released and is in line with the expected result, there is generally a minimum impact on the price movement. However, if the reported result is significantly different to the expected value, volatile price movement may occur as traders try to price in these new and unexpected results.
Publishing times are usually released in advance
You can use an economic calendar to keep up-to-date on various news releases. The date and times of such news releases are published in advance and so you can keep track of them. The financial markets frequently get disturbed by unexpected events. This can cause rapid price volatility and may even change the direction of a trend.
Rapid price movement can occur during a news release
The initial reaction in the currency markets after a news release can be volatile. This is because institutional traders will generally stay out of entering new positions during the release and close short term positions just prior to it. This results in decreased liquidity of the currency pair or asset. After a news release, such as the US non-farm Payroll, a currency pair can quickly whipsaw in both directions, making trading conditions difficult.
Summary
So far, you have learned that:
- forex fundamental analysis involves studying the economy to determine the effect it has on the value of a currency.
- if an economy is determined to be strong, then it is likely that the local currency will rise in value.
- economic reports can be used to determine how strong an economy is.
- these reports are released at set times and the release times are generally published in advance.
- the financial markets react to the reports when they are released.
- the initial reaction after a news release of certain news reports can be very volatile.
