Tuesday, 22 May 2012

Long Term Fundamental Analysis

A. What is Fundamental Analysis?
There are two major schools of thought to analyzing financial markets: fundamental analysis and technical analysis. Fundamental analysis focuses on underlying economic conditions and indicators-for example economic growth rates, interest rates, inflation, and unemployment-, while technical analysis uses historical prices-through charts for example-to predict future movements. Though there exists debate over which school of thought is more accurate, short-term traders prefer to use technical analysis, focusing their strategies primarily on price action; while fundamental traders tend to be more long term focusing their efforts on determining a currency's proper current as well as future valuation.

While the majority of the course will cover technical analysis, an explanation of fundamental analysis is appropriate here as a backdrop to understanding what actually drives currency values and maintaining a big picture perspective.

Fundamental analysis focuses on the economic, social and political forces that drive supply and demand. There are two main factors that impact exchange rate movements from a fundamental perspective: capital flows and trade flows.


Capital Flows
Capital flows measure the net amount of a currency that is being purchased or sold due to capital
investments. A positive capital flow balance implies that foreign inflows of physical or portfolio
investments into a country exceed outflows. As inflows exceed outflows for a specific country, demand for that country’s currency will increase thus increasing that country’s currency value. Conversely, a negative capital flow balance indicates that there are more physical or portfolio investments bought by domestic investors than foreign investors. Therefore, there will be more capital outflows than inflows into the domestic country decreasing demand for that country’s currency and thus that country’s currency value. Generally, global capital will flow to whichever country offers the highest return on investment through high interest rates, economic growth, or growing domestic financial markets for example. So if a country’s stock market is doing well and/or interest rates are high, capital will flow into that country increasing the demand for the country’s currency and causing its value to appreciate.

To clearly explain this, suppose for example that the UK economy is booming, and that its stock market is rallying as well. Meanwhile, in the United States, a lackluster economy is creating a shortage of investment opportunities. In such a scenario, the natural result would be for US residents to sell their dollars and buy GBP to allow for participation in the rallying UK economy. This would result in an outflow of capital for the US and inflow of capital for the UK. From an exchange rate perspective, this would induce a fall in the USD coupled with a rise in the GBP as demand for USD declines and the demand for GBP increases; in other words, the GBP/USD would rise.

Capital flows measure the net amount of a currency that is being purchased or sold due to capital
investments and thus affects the value of exchange rates. As capital flows into a country, international investors must change their “capital” into the domestic currency of the country where it is being deposited. This in turn increases the demand for the country’s currency to where capital is flowing and causes the value of that country’s currency to appreciate. Conversely, capital flowing out of a country will cause that country’s currency to depreciate. Generally, global capital will flow to whichever location or country offers the highest returns. To put this in perspective, imagine you had $100 to deposit anywhere in the world. In the US, you could buy a short term treasury earning 3% or you could change your US dollars into pounds and earn 7%. Clearly you would chose to change your money into GBP (assuming there was no change in the exchange rate). Now think about this occurring on a massive scale as largeinvestors, mutual funds, hedge fuds, corporations, etc deposit their funds in Britain to earn 7%. As investors change their money into GBP, this will increase the demand for GBP and, in turn, cause the GBP to appreciate vs the USD. In sum, GBP/USD will rise.

In later lessons, we will further explain how to incorporate fundamentals into your trading strategy.

Trade Flows
Trade flows are the basis of all international transactions and represent a country's net trade balance of exported goods minus imported goods. Countries that are net exporters - meaning they export more to international clients than they import from international producers, will experience a net trade surplus. This net trade surplus pressures the exporting country’s currency to rise. More specifically, international clients interested in buying the exported product/service must first buy the appropriate currency, thus creating demand for the currency of the exporter. Japan is an example of an export driven economy with a trade surplus. Japan's trade surplus is the major reason that the JPY has not depreciated sharply as a result of their severe economic weakness. They are a net exporter with a current account surplus representing 3% of their GDP. This is the highest of the G-7 countries, and creates a strong inherent demand for the currency for trade purposes, regardless of economic conditions.

Countries that are net importers - meaning they make more international purchases than international sales – experience what is known as a trade deficit, which in turn has the potential to drive the value of the currency down. In order to engage in international purchases, importers must sell their currency to purchase that of the retailer of the good or service; accordingly, this could have the effect of driving the currency down. For example, the US is a net importer, with a very high trade deficit that requires $1.9 billion in daily inflow to prevent a further trade-based depreciation of the USD. Clearly a change in the balance of payments has a direct effect on currency levels. Therefore, it is important for traders to keep abreast of economic data relating to this balance and understand the implications of changes in the balance of payments.

Trade Flows vs Capital Flows:
Because international trade of goods and services is relatively slow, it takes time to affect the FX market. Therefore, traders should generally consider economic data to analyze trade flows when considering the more long term fundamental backdrop for the market. Conversely, traders should consider information on growing equity or bond markets in a country as direct and more immediate indications that capital is flowing in and could have an effect on the currency in the shorter term.

B. Capital Flows
• Capital flows represent money sent from overseas in order to invest in foreign markets. Capital flows measure the net amount of a currency that is purchased or sold for capital investments. The key concept behind capital flows is balance. For instance, a country can have either a positive or negative capital flow.

• A positive capital flow balance implies that investments coming into a country from foreign sources exceed the investments that are leaving that country for foreign sources.
As inflows exceed outflows for any given country, there is a natural demand for more of that country's currency. This demand causes the value of that currency to increase because a foreign investor must change his currency into the domestic currency where he is depositing his money.

• A negative capital flow balance indicates that investments leaving a country for foreign sources exceed investments coming into a country from foreign sources.

When there is a negative capital flow, there is less demand for that country's currency, which causes it to lose value. This is because the investor must sell his local currency to buy the domestic currency where he is depositing his money.

Countries that offer the highest return on investment through high interest rates, economic growth, and growth in domestic financial markets tend to attract the most foreign capital. These countries maintain a positive capital flow. If a country's stock market is doing well, and they offer a high interest rate, foreign sources are likely to send capital to that country. This increases the demand for this currency, and causes it's value to appreciate.

As an example, let us take a booming economy in the United Kingdom and a sluggish economy in the United States. In the UK, the stock market is performing very well, while in the United States there is a shortage of investment opportunities.
In this scenario:

  • US residents sell their US dollars and buy British Pounds to take advantage of a booming economy.
  • Capital flows out of the United States into the United Kingdom.
  • Demand for GBP increases and demand for USD decreases.
  • The value of USD decreases in relation to the value of the GBP.

C. Trade Flows
  • Trade flows are the buying and selling of goods and services between countries.Trade flows measure the balance of trade (exports – imports). This is the amount of goods that one country sells to other countries minus the amount of goods that a country buys from other countries. This calculation includes all international transactions and represents a country's trade balance.
  • Countries that are net exporters export more to international clients than they import from international producers. Net exporters run a trade surplus. This is due to the fact that they sell more goods to the international market than they purchase from the international market. Demand for that country's currency then increases because international clients must buy this currency in order to buy these goods. This causes the value of a country's currency to rise.
  • Countries that are net importers import more from international producers than they export to international clients. Net importers run a trade deficit. This is due to the fact that they purchase more foreign goods than they sell to the international market. In order to purchase these international goods, importers must sell their domestic currency and buy a foreign currency. This causes the value of the domestic currency to fall. As an example, let us look at Japan, which is an export driven economy with a trade surplus. Japan exports more goods to international clients than they import from international producers.
  • Japan's trade surplus is the major reason why the JPY has not depreciated sharply despite severe economic weakness.
  • Japan is a net exporter with a current account surplus of 3% of GDP.
  • This creates international demand to buy JPY in order for international clients to purchase Japanese products.
Clearly a change in the balance of payments from one country to another has a direct effect on currency levels. Therefore, it is important for traders to keep abreast of economic data relating to this balance and understand the implications of changes in the balance of payments.

JPY appreciates despite economic weakness. From 8/2003 – 12/2003 USD/JPY went from 121.00 to 107.00.

D. Capital Flows vs. Trade Flows
What is Fundamental Analysis?
  • Fundamental analysis focuses on underlying economic conditions and indicators - for example economic growth rates, interest rates, inflation, and unemployment. It is more accurate when used in long term trading strategies.
  • Technical analysis uses historical prices and charts to predict future movements in prices. It is more accurate when used in short term trading strategies.
Two major schools of thought exist in regard to the analysis of financial markets: fundamental analysis and technical analysis.
Though a debate exists over which school of thought is more accurate, accuracy is really a function of the trader's time horizon. Short-term traders prefer to use technical analysis because these traders focus their strategies primarily on historical price action. Long term trading is more suited to fundamental traders as they analyze a currency's proper current value as well as future value.
While the majority of the course covers technical analysis, it is necessary to understand what truly drives currency values. Fundamental analysis will allow us to see the big picture and will serve as a backdrop for the rest of the course.

Fundamental analysis is based in pure economics. It looks at the social and political forces that drive supply and demand. To this end, there are two main factors that impact exchange rate movements from a fundamental perspective:
  • Trade Flows
  • Capital Flows
Capital Flows
  • Capital Flows are the amount of currency that is bought or sold in order to invest in foreign markets. Capital flows measure the net amount of a currency that is purchased or sold for capital investments. The key concept behind capital flows is balance. For instance, a country can have either a positive or negative capital flow.
  • A positive capital flow balance implies that investments coming into a country from foreign sources exceed the investments that are leaving that country for foreign sources. As inflows exceed outflows for any given country, there is a natural demand for more of that country's currency. This demand causes the value of that currency to increase because a foreign investor must change his currency into the domestic currency where he is depositing his money.
  • A negative capital flow balance indicates that investments leaving a country for foreign sources exceed investments coming into a country from foreign sources.
When there is a negative capital flow, there is less demand for that country's currency, which causes it to lose value. This is because the investor must sell his local currency to buy the domestic currency where he is depositing his money.

Countries that offer the highest return on investment through high interest rates, economic growth, and growth in domestic financial markets tend to attract the most foreign capital. These countries maintain a positive capital flow. If a country's stock market is doing well, and they offer a high interest rate, foreign sources are likely to send capital to that country. This increases the demand for this currency, and causes it's value to appreciate.
As an example, let us take a booming economy in the United Kingdom and a sluggish economy in the United States. In the UK, the stock market is performing very well, while in the United States there is a shortage of investment opportunities.

In this scenario:
  • US residents sell their US dollars and buy British Pounds to take advantage of a booming economy.
  • Capital flows out of the United States into the United Kingdom.
  • Demand for GBP increases and demand for USD decreases.
  • The value of USD decreases and the value of GBP increases.
Trade Flows
  • Trade flows are the buying and selling of goods and services between foreign producers and foreign buyers. Trade flows measure net exports (exports – imports). This is the amount of goods that one country sellsto other countries minus the amount of goods that a country buys from other countries. This calculationincludes all international transactions and represents a country's trade balance.
  • Countries that are net exporters export more to international clients than they import from international producers. Net exporters run a trade surplus. This is due to the fact that they sell more goods to the international market than they purchase from the international market. Demand for that country's currency then increases because international clients must buy this currency in order to buy these goods. This causes the value of a country's currency to rise.
  • Countries that are net importers import more from international producers than they export to international clients. Net importers run a trade deficit. This is due to the fact that they purchase more foreign goods than they sell to the international market. In order to purchase these international goods, importers must sell their domestic currency and buy a foreign currency. This causes the value of the domestic currency to fall. As an example, let us look at Japan, which is an export driven economy with a trade surplus. Japan exports more goods to international clients than they import from international producers.
  • Japan's trade surplus is the major reason why the JYP has not depreciated sharply despite severe economic weakness.
  • They are a net exporter with a current account surplus of 3% of GDP.
  • This creates international demand to buy JPY in order for international clients to purchase Japanese products.
Clearly a change in the balance of payments from one country to another has a direct effect on currency levels. Therefore, it is important for traders to keep abreast of economic data relating to this balance and understand the implications of changes in the balance of payments.

Trade Flows vs. Capital Flows:
  • Trade flows occur at a relatively slow pace.
  • Capital flows occur almost instantaneously.
Because the international purchase and sale of goods and services is a slow process, the effects that trade has on the FX market takes a much longer time to manifest. Therefore, economic data that involves trade flows should generally be considered for long term trading because it provides a more fundamental…

Capital, on the other hand, is highly mobile. A transfer from your bank account to a bank account in a foreign country can take place with the click of a button. Because of the speed at which these transfers take place, capital flows have a much more direct and explicit effect on the FX market. Traders should consider information concerning growth in equity and bond markets of a country as immediately applicable to the FX market. Success in other markets indicates whether or not capital will flow in or out of a country, which has an effect on domestic currency in a shorter term.

E. The Carry Trade
Carry Trades: An Opportunity to Profit from International Changes in Supply and Demand
The carry trade, also known as interest rate arbitrage, is popular method for trading foreign exchange. However, as with all transactions, carry trades do entail some risk. The chances of losses are great if you do not understand how, why, and when carry trades work best.

How Do Carry Trades Work?
  • A carry trade involves buying a currency that offers a high interest rate while selling a currency that offers a low interest rate.
  • The trader is able to profit from the discrepancy in interest rates by holding the higher interest bearing currency.
Carry trades can be profitable because an investor is able to earn the difference in interest between two currencies when long the higher interest bearing currency of a pair.
Assume that the Australian dollar offers an interest rate of 4.75%, while the Swiss franc offers an interest rate of 0.25%. In this scenario, a trader would buy AUD and sell the CHF. In doing so, he can earn a profit of 4.50% (4.75% - 0.25%), provided the exchange rate between AUD and CHF does not change.

Why Do Carry Trades Work?
  • Interest rates are one of the main ways countries attract foreign investment. Carry trades work because of the constant movement of capital into and out of countries. Interest rates are one of the primary attractions to certain currencies and elicit significant foreign investment. If a country's economy is doing well (high growth, high productivity, low unemployment, rising incomes, etc.), it will be able to offer those who invest in the country a higher return.
  • Profit seeking investors are naturally attracted to the highest rate of returns.
  • Rate of returns in foreign exchange are directly tied to the interest rate on currencies. When making a decision to invest in a particular currency, an investor is more likely than not to choose the one that offers the highest rate of return, or interest rate. If many investors make this exact same decision, the country will experience an inflow of capital.
  • This difference between countries that offer high interest rates and countries that offer low interest rates is what makes carry trades possible.
  • Imagine an investor in Switzerland who is earning an interest rate of 0.25% per year on her bank deposit of Swiss francs. At the same time, a bank in Australia is offering 4.75% per year on a deposit of Australian dollars. Seeing that interest rates are much higher with the Australian bank, this investor would like to find a way to earn this higher rate of interest on her money.
Now imagine that the investor could somehow trade her deposit of Swiss francs paying 0.25% for a deposit of Australian dollars paying 4.75%. What she has effectively done is “sold” her Swiss francs deposit, and “bought” Australian dollars. After this transaction she now owns an Australian dollar deposit that pays her 4.75% in interest per year, 4.50% more than she was earning with her Swiss franc deposit. In essence, this investor has just done a carry trade by “buying” an Australian dollar deposit and “selling” a Swiss franc deposit.

In this scenario:
  • Many investors make the same transaction, exchanging CHF for AUD.
  • Capital flows out of Switzerland and into Australia.
  • Australia attracts more capital because it offers a higher interest rate.
  • This inflow of capital increases the value of AUD.
When Will a Carry Trade Work Best?
  • Carry Trades are most successful when the majority of investors are willing to take on risk.
  • When investors are willing to take on risk, capital flows into high interest bearing currencies.
Things to Bear in Mind When Considering a Carry Trade
  • A carry trade allows an investor to profit from interest rate differentials.
  • Carry trades also involve assuming the risk of the appreciation of the currency the investor has sold.
By entering into a carry trade, an investor is able to earn a profit from the interest rate difference, or spread, between a high interest rate currency and a low interest rate currency. However, the carry trade can turn unprofitable if for some reason the lower interest rate currency appreciates by a large amount.

An ideal carry trade will involve a low interest currency whose economy is weak and has low expectations for growth. However, if the economy were to improve, the country might be able to offer investors a higher rate of return through increased interest rates.
  • Taking the previous example of Switzerland, investors would take advantage of increasing interest rates by buying Swiss francs.
  • This would cause the Swiss franc to appreciate, and would negatively affect the profitability of success of the AUD/CHF carry trade.
  • The higher interest rates in Switzerland would decrease the interest rate spread.
This same sequence of events may currently be unfolding for the Japanese yen. Given its nearly zero interest rates, the Japanese yen has, for quite some time, been an ideal low interest rate currency to use in yen carry trades. However, this situation may be changing as increased optimism about the Japanese economy has recently led to an increase in the Japanese stock market. Increased investor demand for Japanese stocks and currency has caused the yen to appreciate, and this yen appreciation negatively affects the profitability of carry trades like AUD/JPY.

Trade balances
  • Trade balances affect the profitability of the carry trade.
  • Even if a country has a low interest rate, it can still attract investment for the purposes of debt financing.
  • This investment can cause the low interest rate currency to appreciate.
Country trade balances, or the difference between imports and exports, can also affect the profitability of a carry trade. We have shown above that when investors have low risk aversion, capital will flow from the low interest rate paying currency to the high interest rate paying currency. However, this does not always happen.

For example, think about the situation in the United States. The US currently pays historically low interest rates, yet it attracts investment from other countries, even when investors have low risk aversion. This occurs because the US runs a huge trade deficit, meaning the value of its imports are greater than the value if its exports, and this deficit must be financed by other countries. Regardless of the interest rates it offers, the US attracts capital flows for this purpose of deficit financing.

Time-horizon:
Carry trades are long-term commitments.
Before entering into a carry trade, an investor should be willing to commit to a time-horizon of at least six months. This commitment helps to make sure that the trade will not be affected by the “noise” of shorter-term currency price movements.
Summing up, carry trade investors should be aware of relevant factors such as currency appreciation, trade balances, and time-horizon before placing a trade. Any or all of these factors can cause a seemingly profitable carry trade to be unprofitable.

F. Sample Carry Trades
A carry trade is a strategy involving borrowing a currency with a lower interest rate in order to purchase another currency with a higher interest rate. The trader will pay interest at a lower rate for the borrowed currency than he/she will earn on the currency being purchased. This results in the client earning funds due to a positive interest rate differential between the two currencies in the trade.

AUD/USD Monthly
On 09/01/01, the situation in the United States is worrisome. The economy is officially in a recession and geopolitical pressures threaten to weaken the economy even further. The Fed decides to spur growth by aggressively cutting rates. Rates in the US will then decrease from above 4% to 1%. The spread between Australian rates and US rates widens. International bond investors shift their funds to the highest yields and accumulate in Australian Bonds. They need to buy Australian dollars and the AUD/USD increases from the 0.5000 level to the current 0.7000 level. They pocket the 3% interest differential on the bonds for 2 years and the 40% increase in the currency over the same period.

USD/CAD Monthly
Let's look at the same situation, this time using the USD/CAD pair as an example. The Fed decides to spur growth by aggressively cutting rates. Rates in the US then decrease from above 4% to 1%. The spread between Canadian rates and US rates goes from negative to positive. Canadian investors repatriate their funds from the US since they can invest at home and get better returns. Soon enough, US investors realize that they can simply invest across the border and get higher returns. The Loonie rallies and the USDCAD pair falls from 1.6000 to 1.3000. Carry trade investors profit from the interest rate differential, as well as the ensuing downtrend in USDCAD.

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