Fundamental analysis studies the impact of economic, political and social factors on supply and demand. From this perspective capital flows and trade flows are considered the basic drivers of the movement of exchange rates.
Capital Flows
In order to determine the net amount of currency that is traded by capital investments you should examine capital flows. If the value of capital flow is negative, then the amount of outflows exceeds the amount of inflows of capital in the country. It implies foreign investors have acquired less physical or portfolio investments than domestic investors.
For example if the economy of country A is lagging behind, meaning less investment opportunities, whereas the economy of country B is booming, then it is logical that investors from country A will strive to acquire more of the currency of country B. This will be done in order to benefit from the stronger currency of the proliferating country. As a result of the increased demand of country B’s currency, its exchange rate will increase, whereas the exchange rate of currency A will fall.
Basically, there are two types of capital flows:
- Physical FlowThis type of capital flow includes the investments done by corporations in:
- Real estate
- Manufacturing
- Local corporations acquisitions
In order to execute these activities foreign corporations have to purchase more of the local currency. This is done through the sale of their own currency. As a result a movement on the forex market is observed.
Such movement of activities in a foreign country is sometimes driven by the more favorable legislation. Additionally, it may be prompted by the growth potential of the market of the country or a more advantageous financial environment.
- Portfolio FlowThere is a clear link between equity markets and currencies. Since well developed equity markets lead to higher investment opportunities, capital can be more easily moved from one country to another. Thus, proliferating equity markets in a particular country lead to a greater desire by investors to benefit from the provided investment opportunities. As a result more currencies are entering the market. The vice versa is also true when the equity market is not beneficial, which leads to domestic investors transferring their money to foreign markets.A direct relationship between the value of the local currency and the strength of the domestic equity market is observed. Namely, the value of the currency will increase, if the country enjoys strong equity market.There is also a clear link between fixed income markets and currencies. Fixed income investments are preferred investment tool in times of uncertain economic conditions. Thus, if a particular country provides a favorable fixed income environment, then more a shift to this country will be observed. This in turn will lead to a higher demand of its currency and the eventual increase in its value.In order to measure the fixed income capital flows, one should study both the short- and long-term international government bond yields. The tendency is toward investors purchasing more funds of countries that enjoy high assets yield. If this is the case of a particular country, then more investments will be attracted, which will lead to an increase of the local currency.
Trade Flows
The second factor influencing exchange rates is trade flows. The latter represents the net trade balance of a country. A net trade surplus is observed when a country exports more than it imports. Such net exporters enjoy higher exchange rates of their currency, since there is a higher purchase of it in order for foreign buyers to acquire the exported goods and services.
On the other hand, if a country imports more than it exports, then it has a trade deficit. This will eventually lead to a lower exchange rate of the domestic currency, because importers have to sell their currency in order to purchase more of the foreign one to finance the imports.
Finally, you should carefully examine the balance of payments of a country, because it may serve you as an indicator of the value of its currency.
Productivity of a Country
Another fundamental factor that influences the movement of currencies is the productivity of a country. The fiscal and monetary policies that a country applies regarding interest rates can significantly impact the value of its currency; therefore you should include this factor in your fundamental analysis.
