## Lesson 4: The analysis method of exchange rate

### Basic analysis

Purchasing Power Parity (PPP) | Interest Rate Parity (IRP) | Balance of Payments Model | Asset Market Model

The two leading analytical methods of the currency market are fundamental analysis and technical analysis. Fundamental analysis focuses on developing finance, economic theory, and political situation to determine supply and demand factors. Technical analysis observes price and transaction volume data to determine the future trend of these data. Technical analysis can be further divided into two main types: quantitative analysis: using various data attributes to help estimate the limits of over-buying/selling currencies; chart analysis: using lines and graphs to identify significant trends in the composition of currency exchange rates And patterns. The most apparent difference between fundamental analysis and technical analysis is that fundamental analysis studies the causes of market movements, while technical analysis studies the effects of market movements.

When valuing a country’s currency in another country’s currency, the fundamental analysis includes studying macroeconomic indicators, asset markets, and political factors. Macroeconomic indicators include economic growth rates, which are calculated from factors such as gross domestic product, interest rate, inflation rate, unemployment rate, money supply, foreign exchange reserves, and productivity. The asset market includes stocks, bonds, and real estate. Political factors will affect the trust in a country's government, social stability, and confidence.

Sometimes the government will intervene in the currency market to prevent the currency from deviating significantly from undesirable levels. The central bank executes intervention in the money market and usually has a significant but temporary impact on the foreign exchange market. The central bank can unilaterally buy/sell its currency in another country's currency or jointly intervene with other central banks to achieve more significant results. Or, some countries can try to influence currency changes only by issuing hints or threats of intervention.

### Basic Theory of Fundamental Analysis

Purchasing power parity theory stipulates that the exchange rate is determined by the relative prices of the same commodities group. Changes in the inflation rate should be offset by changes in the exchange rate of the same amount but in the opposite direction. Take a classic example of a hamburger. If a hamburger is worth US\$2.00 in the United States and a pound 1.00 in the United Kingdom, then according to the theory of purchasing power parity, the exchange rate must be US\$2 per pound. If the prevailing market exchange rate is 1.7 US dollars per British pound, then the British pound is called an undervalued currency, and the U.S. dollar is called an overvalued currency. This theory assumes that the two currencies will eventually change to a 2:1 relationship.

The main disadvantage of the purchasing power parity theory lies in its assumption that goods can be freely traded, and transaction costs such as tariffs, quotas, and taxes are not counted. Another shortcoming is that it only applies to goods but ignores services, which can have a significant value gap space. In addition, in addition to the difference in inflation rate and interest rate, several other factors affect the exchange rate, such as economic data release/report, asset market, and political development. Before the 1990s, the purchasing power parity theory lacked factual evidence to prove its validity. After the 1990s, this theory seems to only apply to extended periods (3-5 years). In such a span of the cycle, the price eventually moved closer to parity.

Interest rate parity (IRP)

Interest rate parity stipulates that changes in interest rate differences will offset one currency's appreciation (depreciation) against another. Suppose the US interest rate is higher than the Japanese interest rate. In that case, the dollar will depreciate against the yen, and the extent of the depreciation depends on the prevention of risk-free arbitrage. The future exchange rate will be reflected in the forward exchange rate specified on the day. In our example, the forward exchange rate of the U.S. dollar is considered a discount because the Japanese yen purchased at the forward exchange rate is less than the Japanese yen purchased at the spot exchange rate. The yen is viewed as a premium.

After the 1990s, there is no evidence that the theory of interest rate parity is still valid. Contrary to this theory, currencies with high-interest rates generally do not depreciate but increase in value due to the long-term suppression of inflation and is a highly efficient currency.

Balance of payments model

This model believes that the foreign exchange rate must be at its equilibrium level-that is an exchange rate that can generate a stable current account balance. A country with a trade deficit will reduce its foreign exchange reserves and eventually reduce (depreciate) the value of its currency. Cheap currency gives the country's goods more price advantage in the international market and makes imported products more expensive. After a period of adjustment, the volume of imports was forced to fall, and the importance of exports rose, thereby stabilizing the balance of trade and currency.

Like the purchasing power parity theory, the international balance of payments model mainly focuses on traded goods and services while ignoring the increasingly important role of global capital flows. In other words, money is not only chasing goods and services, but more broadly, it chases financial assets such as stocks and bonds. Such capital flows enter the capital account of the balance of payments, which can balance the deficit in the current version. The increase in capital flows gave rise to the asset market model.

Asset market model

The best model so far.

The rapid expansion of financial assets (stocks and bonds) has given analysts and traders a new perspective on currencies. Economic variables such as growth rate, inflation rate, and productivity are the only drivers of currency changes. The share of foreign exchange transactions originating from cross-border financial asset transactions has dwarfed currency transactions arising from trade in goods and services.

The asset market approach treats currency as the price of an asset traded in an efficient financial market. Therefore, currency increasingly shows its close relationship with asset markets, especially stocks.

The U.S. Dollar and U.S. Asset Market-1999

In the summer of 1999, many authorities believed that the U.S. dollar would depreciate against the euro, citing the growing U.S. current account deficit and the overheating of the Wall Street economy. The theoretical basis for this view is that non-US investors will withdraw funds from the US stock and bond markets and invest in markets with healthier economic conditions, thereby drastically depressing the value of the US dollar. And such fears have not dissipated since the early 1980s. At that time, the U.S. current account quickly grew to a record high, accounting for 3.5% of gross domestic product (GDP).

Just as in the 1980s, foreign investors still have such a greedy appetite for American assets. But unlike in the 1980s, the fiscal deficit disappeared in the 1990s. Although the growth rate of foreign holdings of U.S. bonds may have slowed down, the continuous injection of large amounts of funds into the U.S. stock market is enough to offset this slowdown. When the US bubble bursts, non-US investors are most likely to choose safer US Treasury bills than Eurozone or British stocks because Eurozone or British stocks are likely to be struck in the above incident. In the crisis of November 1998 and the stock panic triggered by certain remarks of Federal Reserve Chairman Greenspan in December 1996, such situations have already occurred. In the first case, the net purchases of foreign Treasury bills almost tripled to US\$44 billion; in the latter case, this indicator surged more than tenfold to US\$25 billion.

In the past two decades, the balance of payments law has been replaced by the asset market law in estimating the dollar's behavior. Although the improvement of the fundamental elements of the Eurozone economy will surely help this young currency regain its lost ground, it isn't easy to support this recovery solely based on essential features. Today, there still exists the credit problem of the European Central Bank; up to now, the credit of the European Central Bank is inversely proportional to the frequent verbal support of the euro. The looming risks of the government stability of the Eurozone’s Big Three (Germany, France, and Italy) and the expansion of the European Monetary Union are also seen as potential obstacles to the single currency.

At present, the stability of the US dollar can be attributed to the following factors: zero inflation growth, the safe-haven nature of the US asset market, and the euro risk mentioned above.

Technical analysis

Technical analysis studies past price and transaction volume data and then predicts future price trends. This type of analysis focuses on the composition of charts and formulas to capture major and minor trends and identify buying/selling opportunities by estimating the length of the market cycle. Depending on the period you choose, you can use intraday (every 5 minutes, every 15 minutes, hourly) technical analysis, weekly or monthly technical analysis.

### Basic Theory of Technical Analysis

Dow Jones Theory

The oldest theory in this technical analysis believes that prices can fully reflect all current information. The knowledge available to participants (dealers, analysts, portfolio managers, market strategists, and investors) is already in the pricing behavior Be converted. Currency fluctuations caused by unpredictable events, such as the will of God, will be included in the overall trend. Technical analysis aims to study price behavior and make conclusions about the future direction.

The Dow Jones theory, which mainly developed around the average line of the stock market, believes that prices can be interpreted as including three types of volatility-dominant, auxiliary and secondary. The relevant period varies from less than three weeks to more than one year. This theory can also explain the flyback mode. Flyback mode is the regular phase of the trend, slowing down the speed of movement. Such flyback mode levels are 33%, 50%, and 66%.

Fibonacci flyback phenomenon

This is a widely used group of flyback phenomena based on the ratio of numbers produced by natural and artificial wonders. This phenomenon is used to determine the magnitude of the rebound or retracement between the price and its underlying trend. The most crucial flyback phenomenon levels are 38.2%, 50%, and 61.8%.

Elliott wave

Elliot scholars classified price trends in a fixed wave pattern. These patterns can represent future indicators and reversals. Waves that move in the same direction as the movement is called impulse waves, and waves that move in the opposite direction are called correction waves. Elliott’s wave theory divides the push wave and the correction wave into 5 and 3 main principles. These eight directions form a complete wave cycle. The period can range from 15 minutes to decades.

The challenging part of Elliott's wave theory is that one wave cycle can be composed of 8 wavelet cycles, and these waves can be further divided into push and correction waves. Therefore, the key to Elliott's lock is to identify the particular lock's environment. Elliot also used the Fibonacci flyback phenomenon to predict the peaks and troughs of future wave cycles.‌‌What are the contents of technical analysis?

Spot the trend

Regarding technical analysis, the first thing you may hear is the following motto: "The trend is your friend." Finding the dominant trend will help you view the overall market orientation and give you more keen insight-especially when shorter-term market fluctuations disrupt the overall market. Weekly and monthly chart analysis is best used to identify longer-term trends. Once you find the general direction, you can choose the movement in the period you want to trade. In this way, you can buy or sell during the uptrend and sell during the downtrend.

Support and resistance levels are the points on the chart that experience continuous upward or downward pressure. The support level is usually the lowest point in all chart modes (hourly, weekly, or yearly), and the resistance level is the highest point (peak point) in the chart. When these points show a recurring trend, they are identified as support and resistance. The best time to buy/sell is near the support/resistance level that is not quickly broken.

Once these levels are broken, they will tend to become reverse obstacles. Therefore, in an uptrend market, the split resistance level may become support for an upward trend; however, in a downtrend market, once the support level is broken, it will turn into resistance.

Lines and channels

Trend lines are simple and practical tools in identifying the direction of market trends. The upward straight line is formed by connecting at least two consecutive low points. Naturally, the second point must be higher than the first point. The extension of the straight line helps to determine the path the market will follow. Uptrend is a specific method used to identify support lines/levels.

Conversely, the downward line is drawn by connecting two or more points. The variability of transaction lines is, to some extent, related to the number of connection points. However, it is worth mentioning that the facts do not have to be too close.

A channel is defined as an upward trend line parallel to the corresponding downward trend line. Two lines can represent a corridor where prices are up, down, or horizontal. The common attribute of a channel that supports trend line connection points should be located between the two connection points of its reverse line.

Average line

If you believe in the philosophy of "the trend is your friend" in technical analysis, then the moving average will benefit you a lot. The moving average shows the average price at a specific time in a particular period. They are called "moving" because they are measured simultaneously and reflect the latest standard.

One of the disadvantages of moving averages is that they lag behind the market, so they are not necessarily a sign of trend change. To solve this problem, using a short-period moving average of 5 or 10 days will reflect recent price movements better than a 40 or 200-day moving average.

Alternatively, a moving average can also be used by combining two standards with different periods. Whether the 5- and 20-day moving averages or the 40- and 200-day moving averages are used, a buy signal is usually detected when the shorter-term average crosses the longer-term average upward. In contrast, a sell signal will be prompted when the shorter-term average crosses the longer-period average downward.

There are three mathematically different moving averages: simple arithmetic moving average, linear weighted moving average, and square factor weighted average. The last one is the preferred method because it gives more weight to the most recent data and considers the data throughout the cycle of financial instruments.

## Comparison of the foreign exchange market and the stock market

From choosing investment tools, the foreign exchange market and the stock market have their characteristics. The following is a simple comparison for investors' reference.

Comparison of investment methods, project stocks and foreign exchange (firm offer)
Participate in the domestic stock market and international foreign exchange market
Market size: Daily volume of RMB 10 billion, Daily volume of USD 1.5 trillion
Supervisor China Securities Regulatory Commission International Industry Practices and Central Banks
Poor liquidity, it is best if there is a price limit, but no price limit
Account opening procedures shareholder code card + securities company account number bank foreign exchange account number
No high and low limits on the amount of investment
Trading hours: Monday to Friday, 9:30—11:30, 1:00—3:00 in the afternoon, 24 hours a day, Monday to Friday
Settlement cycle T+1 T+0
Settlement currency RMB, Hong Kong dollar, U.S. dollar All foreign currencies except RMB
More than 1,000 trading varieties, four major currencies + more than a dozen cross exchange rates
Transaction methods Self-service terminal, telephone, Internet Internet, telephone, self-service terminal, counter
The average volatility is about 50% per year and 15% per year, 0.8-1.5% per day
Transaction cost 1-3‰ handling fee no handling fee
The annual profit potential is uncertain about 20%
Risks ST, PT, delisting countries die

On the whole, the foreign exchange market is more standardized and mature, the trading methods are more flexible and convenient, the profit margin is more significant, and the risk can be controlled within a specific limit. It is a stable and mature investment method for professional investors and institutions, and individuals holding foreign exchange.