Chapter 4: What Moves Forex Prices?

Supply and Demand

• The Forex market, just like every other market in the world, is driven by supply and demand.

• Having a good grasp on supply and demand will make all of the difference in your Forex trading career because it will give you the ability to sift through the mountain of news that is produced every day and find those messages that are most important.

• Supply is the measure of how much of a particular commodity is available at any one time, or a measure of buying pressure verse selling pressure at any one time. As the supply of a currency increases, the currency becomes less valuable. Conversely, as the supply of a currency decreases, the currency becomes more valuable.

• Think about rocks and diamonds. Rocks aren’t very valuable because they are everywhere. There is a large supply of rocks in the world. Diamonds, on the other hand, are expensive because there aren’t that many of them in circulation. There is a small supply of diamonds in the world, and you have to pay a premium if you want one. It’s a crude analogy, but the point is made.

• Fundamental and Technical analysis are the two major disciplines in the Forex market and every other market for that matter.

• Fundamental analysis is the study of what is happening in the world around us. It includes things such as news, economic announcements and policies, company earnings and most importantly for FX … interest rates.

• Technical analysis is the study of what is happening on the chart of a particular currency pair. We will be discussing technical analysis at length during this course.

• Both forms of analysis are built upon a foundation of supply and demand. As traders we need to have only a brief understanding of fundamental analysis and focus much more on Technical Analysis.

• Traders favor the currency with the higher interest rate verse the lower interest rate.

• AUDJPY, carry trade, when we sell Yen, we effectively borrow at 0.5 %, and then buy AUD and invest in 5.5%. The differential is 5%.

• Economic Factors change the relationship and pricing over time.

• Different currencies pay different interest rates. This is one of the main driving forces behind foreign exchange trends. It is inherently attractive to be a buyer of a currency that pays a high interest rate while being short a currency that has a low interest rate.

• Although such interest rate differentials may not appear very large, they are of great significance in a highly leveraged position. For example, early this decade, the interest rate differential between the US dollar and the Japanese yen had been approximately 5% for several years. In a position that can be supported by a 5% margin deposit, this results in a 100% profit on capital per annul when you buy the US dollar.

• From a pure interest rate differential viewpoint, you have an advantage of 100% per annul in your favor by being long US dollar and an initial disadvantage of the same size by being short.

• Such a situation clearly benefits the high interest rate currency and as result, the US dollar was in a strong bull market all through 2005.

• Generally, the currency with the higher interest rate will be strongest unless there is some major economic event for the high interest rate such as runaway extremely high inflation

• Basic understanding is that we have a cost or credit in carrying either higher yielding or lower yielding currency.

• If we short AUDUSD, we would pay interest because the AUD has a higher interest rate then USD, if we went long we would receive interest because we own the higher yielding currency. 

• “Interest,” “roll-over,” “swap rate,” and “cost of carry” are all terms used by dealers to describe the premium paid or charged on each forex pair.

• Each Forex pair has an interest payment and charge associated with holding the position long or short.

• Depending on the pair you trade, and what direction your trade is, you will pay or receive interest.

• The premium can change on a daily basis but will typically not change very much.

• This interest premium is derived from the difference in short term interest rates between the two economies represented by the currencies in the pair you are trading. The short term interest rate used is the overnight LABOR rates. These are typically set by the British Banker’s Association and are changed on a daily basis.

• Interest premiums are paid in different ways, depending on the dealer.

• The most common ways that you are paid or charged this interest in through an actual payment, the amount will be added or deducted to your account at the days close. Or, the broker may reset your position in a more or less favorable price.

• This process of resetting your position means that if you were long and are owed a premium your entry price is reset to be lower than when you first entered. Likewise, if you are short and owed a premium your entry price will be reset to be slightly higher than it was originally.

• Trade Balance

• GDP

• Consumer Price Index

• Producer Price Index

• Payroll / Employment

• Durable Goods Orders

• Retail Sales

• Housing Starts

• Interest rates