What is Fundamental Analysis ?

Fundamental analysis is based on using theoretical models of currency price formation and investigating major factors (not only economical) which influence the currency rates. Fundamental analysis lies in examining macroeconomic indexes and indicators, markets of securities, and political factors for one national currency in correlation to another currency. Macroeconomic indicators include the growth of GNP, interest rate, inflation, unemployment, money reserves, currency reserves, and productivity of work. Securities' markets stand for shares, bonds, and real estate. Political factors reflect the level of credibility to given government, its stability, confidence of others in it. 

Sometimes the governments interfere into currency forming forces of the market to prevent them from unfavorable tendencies. This interference is performed by Central Banks, and they may have sufficient impact upon the market situation. Central Bank can buy/sell a great amount of its national currency or take part in coordinated actions with other Central Banks for getting bigger effect on the market.

There are several theories for currency price formation. 

Parity of purchasing capacity.

This theory states that currency rates are defined by relative prices of "basket of goods" - a set of certain products. Parity of purchasing capacity has two versions: absolute and relative. According to absolute version, the exchange rates are defined by a simple correlation between general price level of two countries (this general price level shows single average price for all the goods which are produced inside the country). This version can be used only if it is possible to find countries which produce and consume the same goods. Plus, absolute version does not take into account transporting costs, expenses for breaking the trading boundaries and importance of trade marks.

Relative version proves that percentage change in currency rate within certain period of time should be equal percentage change in price level inside this country and abroad. This version has its own flaws: problem of trading limits, averaging prices when calculating their indexes. Parity of purchasing capacity and its theory do not include the prices for services, and possible currency rate changes (which often change irrespectively of financial and political reasons). 

Flexibility theory

According to this theory the currency exchange rate shows the price of national currency which makes the trading balance of this country more equal (i.e. more balanced). The country with tradiecting the principles of this theory arise constantly. 

Equal interest rates

This theory implies that revaluation or devaluation of one currency against another should be neutralized by changes in the level of interest rates. The currency with higher interest rate will be losing its value is respect to the currency with lowe

ng deficit will be losing reserves of foreign currency: this will cause devaluation of national currency. Cheaper currency makes the goods of this country cost lower on the world market, whereas the import becomes more expensive. After a while the amount of import decreases, export gets more trading volumes, and the trading balance finally comes to a balance together with the national currency. This theory also has got its drawbacks. The currency rate is less flexible during short periods of time, only longer time spans show good currency flexibility. Moreover, additional factors affr interest rate. However, this theory finds no examples recently. On the contrary, the currencies with higher interest rates grew in price. But this may be caused by huge power of inflation expectations.

Theory of securities' market. The swift growth in trading volumes of securities (shares and bonds) has changed the attitude of analysts and traders to currencies. The amount and size of currency market transactions, made from international trading of securities, is really huge in comparison with turnovers from goods and services. Theory of securities' market treats currencies as prices for shares and bonds, under the circumstances of effective financial market. Due to this, currency markets become more closely related to the securities' markets (especially to shares). 

Another important factor is represented by the dominating expectations of the market. Timely receipt of information and its adequate analysis can help a lot in increasing the effective market trading.