When you are studying the currency exchange market, you usually come across a variety of economic theories and methods involved in the Forex market. It is extremely important that the “rookie” investor/trader understand the theories involved as it lends a better perspective as to the trading philosophies that are employed by investors who actively participate in the Forex market. There are 4 of these major economic theories when you are involved in trading currencies.
Theory #1 – Balance of Payments
There are two segments involved with a country’s balance of payments (BOP), which is a listing of all transactions between one country and others during a particular period of time. When you are discussing BOP it is normally discussed from either a standpoint of capital accounts or current accounts. This is a measure of influx and outgo of a nation’s capital and goods.
Normally, the BOP Theory looks at a country’s current accounts rather than the capital ones. This is used to determine the direction that a currency is heading in based on the trading of tangible goods. When a country runs a large current account with either deficits or surpluses, its monetary exchange rates are said to be out of equilibrium or are unbalanced. Adjustments to the currency rates will need to be made. When a country’s imports outweigh their exports, this is considered a deficit and it normally devalues the currency. Conversely, when exports exceed imports, a surplus exists and the currency will normally ascend in value.
Theory #2 – Interest Rate Parity
This exists when the difference between two country’s interest rates are equal to the difference between forward exchange value versus the spot exchange value. Due to the connection between interest rates and the two aforementioned values, interest rate parity plays an extremely significant role in the Forex market.
The mindset is that if there is no difference in the rates of interest between to comparative countries, then there most likely won’t be any opportunities for financial gain. This is due to the fact that risk ceases to exist, therefore thwarting much hope for any monetary gain via investing.
Theory #3 – International Fisher Effect (IFE)
This theory basically states that any expected changes in currency rates between two countries is roughly equal to the differential of nominal interest rates between the two subject countries. The theory suggests that exchange rates between two nations should fluctuate based on amounts that are most like these nominal interest rates. If the rate is lower in one of the countries compared to the other, than its exchange rate should appreciate against the higher exchange rate — or so the theory would predict.
Theory #4 – Purchasing Power Parity (PPP)
Estimating the amount of adjustments needed between two country’s exchange rates so that these rates equal the purchasing power of the countries is how PPP functions. The theory mandates that the price levels of the two countries in question should be equal once the adjustments to the exchange rates are completed. The theory also is also suggestive of the “law of one price” wherein the pricing of identical goods be the same on a global basis.