One of the most important things every broker should be aware of, is there are 2 types of analysis when it comes to forex trading – technical and fundamental. During the years experts have always been arguing which one is the best, but so far, there is not a clear answer. However, in the next lines we would like to pay attention to the fundamental analysis while and try to explain it to people who have less to no experience with trading.
What a person needs to know about the fundamental analysis is that it looks to measure the true value of a certain company. But that’s not all. Along with the true value the analysis tries to base investments upon this type of calculations. And when it comes to forex markets, you have to know that forex fundamental traders evaluate currencies and their countries, later, just like companies, use economic announcements in order to gain idea of the true value of the currency.
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Probably the most important thing a trader should follow is the economic data, different political events, etc. which come out on daily basis about a certain country. Actually this information is similar to the news that is announced out about a stock. The value changes over the time due to lots of factors such as financial strength, economic growth, etc. So if you are about to become a fundamental trader, you need to be aware of all those things and look for all this information in order to evaluate the currency of the country you have chosen. This will definitely help you!
Keeping in mind that the forex strategies based on fundamental analysis are numerous, we can easily write a book on this subject. However, in order to gain a better idea of the trading opportunity, we will go over one of the well-known situations – forex carry trade. But before we do this, we would like to once again point out that it is extremely important to know that a good trader has to have at least a brief idea of both fundamental and technical analysis because this will help him catch the movements of the market more accurately and therefore boost his performance and profits.
A Breakdown of the Forex Carry Trade
If you haven’t heard of this strategy, then keep reading. Basically, a currency carry trade is a strategy in which the trader starts selling a currency which offers lower interest rates and buys another currency that has higher interest rates. Said in other words, you borrow at low rate and then lend at higher one. If you like this strategy and decide to use it, you have to know that you have to be good and be able to seize the moment and capture the difference between the 2 rates. In most cases people trade with high leverage and in times like this even a small difference between the rates can make a huge difference. Along with the whole process of capturing the difference of rates, the investors often see the value of the higher currency rise when money flows into the so called higher yielding currency which actually bids up the value.
Here are some real life examples – the yen carry trade can be found starting in 1998 when Japan decided to decrease its interest rate to almost zero. The investors are aware of this fact and capitalize upon these lower interest rates so they decide it is better to borrow a large sum of Japanese yen. Right after the borrowing the currency is converted into US dollar which is then used to buy US treasury bonds at 5%. And since the Japanese yen rate was set to zero, the investor would be paying nothing to borrow the Japanese yen and earn the entire yield on his US treasury bonds. And you can imagine how greatly the sum can be increased with the help of leverage
If you are not good with leverage, then let us try to explain to you how things are done. For example, if the leverage is 10 times, that would create a return of 30% on a 3% yield. If we have to speak in sums – if you deposit 5000$ in your account and the leverage is 10 times – this means you will virtually have 50 000$. And if you implement the currency carry trade from the above stated example, you will be earning 3% per year. So at the end of the year you will have 51500$ (3% annual gain). And because you have only invested 5000$ instead of 50 000$ (leverage), your return will be 30%. However, we know that it sounds too easy to be true, so keep in mind that this strategy works only if the value of the currency pairs remains unchanged. Due to this reason most of the forex carry traders are looking not only to earn the differential of the interest rates, but also to capital the appreciation. The key thing to remember is that even the smallest difference between the interest rates can generate a huge profit, especially if you are using leverage. Plus, most of the currency brokers require a minimum margin to earn interest for carry trades.
However, the above transaction will be extremely complicated by changes to the exchange rates between the countries. So, if the lower yielding currency starts to appreciate against the higher yielding one, the gain earned between the two could be easily eliminated. One of the major reasons that can make this happen is the risks of the higher yielding currency are sometimes too much for the investors, and due to this fact, they would prefer to invest in the lower yielding currency, which is considered as safer. Usually the carry trades are long term in nature, so they can go through lots of changes over the time – for example, rising rates in the lower yielding currency – this will also attract more investors, but on the other hand will lead to currency appreciation which will diminish the returns of the overall carry trade. So due to this reason the future direction of the currency pair is extremely important.
To make things crystal clear – imagine that the interest rate in the US was 5% while in Russia – 10% – this provides a carry trade opportunity for traders to short the US $ and to long the Russian ruble. So if a trader borrows 100$ US (5%) for a year and then converts it to rubles at rate of 25USB/RUB(25 000), and assuming there are no currency changes, then this will give the trader a win of 2500 rubles and a total of 27500, which converted in US dollars will be 1100$. And since the trader borrowed 1000$ at 5% he owes 1050% to the bank, which gives him a win of 50$.
Another scenario we want to pay attention to is if there was another crisis in Russia, such as the one in 1998 during which the government defaulted on its debt and the consequences were large currency devaluation in the Russian market. So if by the end of the year the exchange rate was 50 USB – RUB , those 27 500 rubles would be converted into only 55$. And since the trader owes 1050$ to the bank, this means that he will experience a severe loss due to the currency fluctuation.
You should now have a basic idea of some good economic and fundamental ideas that will help you understand the forex trading better. The whole part of movements of currencies is basically one of the most important parts that a future trader has to pay close attention to. Keep in mind that the best way that you can learn is to practice.
So one of the most important things that should be taken away from this section, is that currencies and countries are constantly changing, based on different fundamental factors, such as interest rates and economic growth. And based on the economic theories mentioned above you should have a good idea of the impact.
And last but not least we would like to redirect your attention once again to something we’ve mentioned earlier. In order to be good and successful forex broker, you need to acquire knowledge not only in fundamental analysis, but in technical as well. Keep in mind that the fundamental analysis takes a lot more time, but sometimes the results will be better than the ones you would have achieved if you have used technical. So take your time, study the economy of a certain country, see its political issues, interest rates and other factors that influence the fundamental analysis and make your move. Even if you are not as successful as you wish at the beginning – don’t worry – experience comes with practice. So once again, don’t lose hope, choose a currency pair and take your time to trade with it.