Basic Fundamental Question

Trading Discussion News and Economy
1

I am fairly new to Forex and I have devoted most of my time on the technical side of trading and now I am working on transitioning to learning more fundamental analysis.

Just for an example let’s look at the EUR/USD pair. I am not sure if I am way off base but basically I understand EUR/USD to mean you are borrowing Dollars to invest in Euro’s.

Looking at the exchange rate you can see that 1 Euro equals 1.4 Dollars. Now if you looking at both currencies’ interest rate we can see that the Euro’s rate is 1.25% and the Dollars is .25%.

Knowing this couldn’t you now set up a formula to determine whether it would be better to buy or sell the EUR/USD pair?

$10 Converted to Euro’s = E 14

E 14* EU Interest Rate = E .175

E .175 Converted back to $ = $ .1225

$10 * US Interest Rate = $.025

So my theory is as long as the value generated from investing in Euro’s ($.1225) is greater than the value of just investing in Dollars ($.025) the EUR/USD will continue to raise therefore you would only want to take long positions. If the opposite was true you would only want to look to take short positions.

Does this make sense or have I completely missed it.

Thanks

2

There is a term for your theory. It’s called a carry-trade.

3

If interest rates were the only driver of exchange rates then sure. The are, however, numerous other influencing events. In terms of fundamental exchange rate pricing theory, look up Purchasing Power Parity as a good starting point. I’m not saying it’s what drives things day-to-day, but it will give you an idea of some of the bigger picture influences.