Economic Theories & Models in Currency Trading

In this article, a review of economic theories and models in currency trading is presented to give readers an overarching idea behind the use of these economic theories and models in forex markets.

The major currency trading economic theories deal with parity conditions. A parity condition is defined as an economic explanation of the price at which two currencies should be exchanged, based on factors such as inflation and interest rates. Some economic theories in currency trading are based on economic factors of a country like capital flows, trade and economic situations. Let us review the currency trading theories & models in brief here:

Purchasing Power Parity

According to Purchasing power parity (PPP) is a currency trading economic theory, the exchange rates between currencies should be in equilibrium when the their purchasing power is the same in each of the two countries. This states that the exchange rate between two countries is equal to the ratio of the two countries' price level of a fixed basket of goods and services. When a country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must depreciated in order to return to PPP. The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency.

Interest Rate Parity

The concept behind Interest Rate Parity (IRP) currency trading economic theory is same as of PPP economic theory which states that for there to be no arbitrage opportunities, two assets in two different countries should have similar interest rates, as long as the risk for each is the same. The IRP theory basics suggest that the law of one price, in which the purchase of one investment asset in one country should yield the same return as the exact same asset in another country. If not than the exchange rates need to get adjusted to make up for the difference.

International Fisher Effect

The International Fisher Effect (IFE) theory suggests that difference in the rate of interest between two countries should be taken in to account to estimate the future change in the cash exchange rate between currencies in the foreign exchange market

Balance of Payments Theory

The Balance of Payments theory takes into account current account of a country dealing with trade of tangible goods, to get an idea of exchange-rate directions. A country which has a large surplus or deficit current account means that a country's exchange rate is out of equilibrium. In order to bring the current account into equilibrium, the exchange rate will need to adjust over time. So in case a country is running a large deficit which means more imports than exports) the domestic currency will depreciate otherwise a surplus would lead to currency appreciation.

Continuing the review of economic theories and models let us now have a look at economic theories on currency trading. These are secondary theories which have been labeled as models rather than theories, although they originate from economic theories to begin with.

The Asset Market Model

The Asset Market model is focused on monetary influx of a country by foreign traders/investors who are purchasing certain financial instruments like stocks, bonds or both of these. Countries expect a large inflow of investments in their available financial instruments, and also hope to see an increase value for their currency. This makes sense because of the fact that the foreign investors need to convert their own country’s currencies over to the particular currency rate of the nation so that they can buy the intended financial instruments in that particular country.

In this currency trading model, the capital account of the trade balance is taken into consideration versus the current account balance of trade. Since the capital accounts of most countries are starting to outweigh their current account balances, this model in currency trading is being applied more than the currency trading models.

The Monetary Model

The Monetary currency trading model focus is on monetary policy of a country and determines the currency exchange rate. Most of the countries have monetary policies which deal with monetary supplies such as the amount of money which is printed by treasury prints of a country. When this is combined with the interest rates set by country’s central banks, it will oftentimes determine the amounts of monetary supplies available in the country.

Real Interest Rate Differential Model

In simple terms, the Real Interest Rate Differential currency trading model suggests that the countries with higher real interest rates will see their currencies appreciate against countries with lower interest rates. This is based on the fact that the traders from all over the world would move their cash to the countries which have higher real rates so that they get higher returns on their investment which results in the higher bid price of the higher real rate currency.