Fundamental analysis is a method of evaluating the intrinsic value of an asset and analyzing the factors that could influence its price in the future.
It analyzes economic, political, and social events in an effort to determine present and future economic trends. In other words, the fundamental approach analyzes the sources of price movements in currencies.
This form of analysis is based on external events and influences, as well as financial statements and industry trends.
The goal of fundamental analysis is to determine whether or not the price of an asset is overvalued or undervalued.
For stock traders, fundamental analysis involves poring over income statements and balance sheets of individual companies. But the way we define fundamental analysis differently when it’s used to trade currencies.
Fundamental analysis is a way of understanding the changes in market valuation by analyzing economic, social, and political forces that affect the supply and demand of a currency.
In forex, the idea behind this type of analysis is that if a country’s current or future economic outlook is good, their currency should strengthen.
Fundamental analysis involves studying economic trends and geopolitical events that might affect a currency’s price.
The better shape a country’s economy is, the more foreign businesses and investors will invest in that country. This results in the need to purchase that country’s currency to obtain those assets.
Although the desirability of a country’s goods or services will influence the demand for its currency, investment opportunities in the country will also be a major factor.
In particular, traders in the forex market will buy or sell currencies based on their expectations of how its exchange rate will change due to:
- Political instability in its own country or other countries.
- Uncertainties in the global market. For example, during the recent Coronavirus Crisis, demand for U.S. dollars surged as investors looked for a safe haven for their money.
- Differences in interest rates between countries. When a country’s interest rates rise, its currency appreciates as foreign investors seek higher returns than they can get in their own countries.
- Differences in economic growth between countries. For example, developing nations that have implemented successful economic reforms may experience currency appreciation as foreign investors seek new opportunities for growth.
Forex traders who utilize fundamental analysis often keep one eye focused on price action while keeping the other on financial news.
They will study the news for information on the political climate, international relations, natural disasters, and other global events.
Fundamental factors that many traders use when deciding whether to enter, stay with a trade, or exit, besides those already mentioned, include unemployment rates, inflation, fiscal policy changes, and stocks/bonds/money markets.
For example, let’s say that the U.S. dollar has been gaining strength because the U.S. economy is improving.
As the economy gets better, raising interest rates may be needed to control growth and inflation.
Higher interest rates make dollar-denominated financial assets more attractive.
In order to get their hands on these lovely assets, traders and investors have to buy some U.S. dollars first. As a result, due to higher demand, the value of the U.S. dollar will likely increase.
Fundamental Analysis (FA) vs. Technical Analysis (TA)
While fundamental analysis looks to a larger picture around the price of an asset. considering as many influencing factors as possible, technical analysis is strictly focused on historical market data and market charts.
While fundamental analysis seeks to determine the real value of a trading asset, technical analysis is used as a tool to study historical price action based on trends, chart patterns, and technical indicators.