Fundamentals of Currency Evaluation

Many forex traders wonder what determines the value of a nation's currency.

A number of factors make up the fundamentals of currency evaluation which usually involve the countries' overall economic prospects, as well as the monetary policy set by each individual country's central bank.

Relative Valuation

In the forex market, the value of a paper currency is generally expressed in terms relative to the value of other paper currencies, rather than in absolute terms. Nevertheless, the price of gold, the world's primary hard currency, when expressed in a country's currency could be considered an absolute valuation of that paper currency.

The value of a nation's currency quoted in relation to another nation's currency comprises the foreign exchange rate for that particular currency pair. This market determined evaluation will typically respond to the long and short term economic prospects of both nations and to their respective business and interest rate cycles.

While some economists postulate that fluctuations in the forex market are essentially a random walk in time, and this random walk theory has even been used in the development of currency option pricing models.

Nevertheless, an examination of a currency's price action over time provides considerable evidence to the contrary.  For example, when plotted over a prolonged period, a currency pair will tend to show tendencies to trend in a particular direction.

This directional movement can often be attributed to trends or gradual, managed shifts in the monetary policy of one country's central bank relative to the other country's central bank.

A Nation's Currency's as the Country's Stock

In much the same way as a corporation's stock reflects the public opinion of the corporation's worth, the currency of a nation tends to reflect how the world market values the economic prospects and the future of a country in relation to other countries.

If a corporation is doing well, with increasing earnings and higher dividends to its stockholders, the stock of that company will tend to appreciate. In the same way, a nation which is doing well economically and whose interest rates attract investment, will usually appreciate more than a country with a slower economy and lower or declining interest rates.

Of course, the example of currency valuation in this case may be an oversimplification of the process, especially given the complicated nature of the world marketplace and the complex interaction of factors of supply and demand.

Nevertheless, this type of comparison can provide a simple framework for stock-oriented traders to understand how the foreign exchange market values currencies.

Currency Reserves and How They Affect Valuation

Certain currencies are treated as "reserve currencies". Such reserve currencies are often held in central banks and can be used to intervene in the markets to support the home currency. Having this status also means that the currency is generally accepted internationally for the payment of debts or for the purchase of commodities.

The U.S. Dollar has traditionally been held for this purpose, as well as being the designated reserve currency involved in the purchase of key commodities like gold and oil.

These factors have effectively prevented the U.S. Dollar from weakening against other currencies, despite economic downturns and other serious fiscal and trade balance problems facing the United States. Nevertheless, these weaknesses have seen the U.S. Dollar depreciate in value relative to hard asset commodities like gold and oil.

Other Fundamental Factors Involved in the Valuation of Currencies

One of the main factors involved in the valuation of currencies, as most forex experts would agree, consists of the interest rate differential between the two currencies comprising the currency pair in question.

Nevertheless, some other fundamental factors that affect currency evaluation include the following:

• Economic prospects for growth.
• Inflation or deflation rate and forecasts.
• Trade deficits or surpluses.
• The nation's money supply.
• The nation's credit rating.
• The security used to back the currency, if any.

All of these valuation elements will tend to affect the exchange rate on currency pairs to some degree. Economists often assign weights to these factors that pertain to each currency in order to make long term exchange rate forecasts.

Basically, keeping an eye on the fundamental economics of the countries involved can be a useful indicator for forecasting long term trends in the valuation of one currency in relation to another.