Market participants can trade futures contracts that represent the relationship between two currencies, also known as the foreign exchange (Forex, FX) market. FX futures contracts are regulated and traded on the open market, just like all futures contracts, which is a major difference compared to the cash Forex market, where each dealer sets their own prices with no common exchange. This transparency in currency futures benefits foreign exchange traders.
FX contracts are priced based on how much of one country’s currency it takes to buy one unit of another country’s currency. Contracts, like Euro/U.S. dollar futures, allow you to trade based on the exchange rate between the euro and U.S. dollar. Most futures contracts are based on a foreign currency in terms of U.S. dollars; the Euro/U.S. dollar futures contract is priced based on how many U.S. dollars it takes to buy one euro.
You can also trade cross rate futures, which allow you to trade the relationship between two foreign currencies, such as Euro/British Pound futures, where both the base and foreign currency are not in U.S. dollars. The fundamental analyst will look at certain factors to determine where the price of the currencies they are trading might move next.
Since exchange rates are a direct comparison of two currencies, the fundamental analyst will evaluate the relative differences between economic factors rather than their absolute values. The analyst will look at factors that make the economies of the two countries different and will attempt to determine how each economy will perform in the future, allowing them to make an assumption about the movement of the exchange rates between the two countries. While the analyst will spend the most time comparing the two countries in terms of relative values, the absolute value each country’s economy will also impact the exchange rate.
For example, if you compare two currencies where there is 20% or higher inflation, the economic conditions will be much different than if you compare two currencies where the countries have less than 5% inflation. The difference in inflation rates between two countries will tend to have a larger effect than the absolute level of inflation.
Since futures are priced as a ratio, there are a combination of changes that can influence price:
- The base currency can strengthen, thus decreasing the price of the currency futures contract
- The base currency can weaken, increasing the price of the currency futures contract. For example, if the U.S. dollar strengthens against the euro, the price of the EUR/USD futures contract will decrease
- The quote, or terms, currency can strengthen, increasing the price of the currency futures contract
- The quote, or terms, currency can weaken, decreasing the price of the currency futures contract. For example, if the euro strengthens against the U.S. dollar, the price of the EUR/USD futures contract will increase
There are also a number of economic factors that affect the price of currency futures including inteste rates, inflation and trade with foreign countries.
Fundamental analysts will look at interest rates, and variables that affect interest rates, for the two currencies they are trading.
Interest rates impact the demand for currencies. If interest rates are high in a particular country, the demand for their bonds will be high as investors look to make investments that offer a higher relative rate of return compared to the alternatives. As investors buy bonds, the demand for the currency increases because the foreign buyer needs to exchange their currency for the foreign currency to purchase the bonds. This demand leads to an increase in the relative value of that country’s currency.
Fundamental analysts will look at the relative levels of inflation in each country to evaluate the strength of each currency.
Inflation decreases the buying power of a country’s currency. This causes a country with higher inflation to have a weaker currency, meaning the price of the foreign exchange futures will increase.
For example, if the rate of inflation in the United States is higher than the rate of inflation in the United Kingdom, the U.S. dollar will decrease in price relative to the British pound. A trader interested in the GBP/USD futures contract will see the price increase, meaning it will take more U.S. dollars to buy a British pound.
Trade between countries will influence the relative value of a country’s currency. Countries that export more will have a currency more in demand, increasing the relative value of their currency.
If the United States exports more good than it imports, demand for its currency will be high and the value of the dollar will increase. If the U.S. exports relatively more goods than the European Union, then the U.S. dollar might increase in value and the EUR/USD futures contract could decrease in price.
The interactions can be complex and fundamental traders will create models to show the relationships between the economy and foreign exchange futures.
Peter Knight Advisor