Hello, fellow traders and readers interested in the topic of currency speculation!
The national currency – a topic close to everyone who was going through an economic crisis or default. In a period of rapidly changing frightening numbers on the scoreboard exchange points, many of us criticized the Central Bank for the “inept” management of the value of the national currency.
After reading the article, you will get the opportunity to quickly and easily calculate the real exchange rate of the national currency or define it for any pair in the Forex market.
Algorithms of calculations of the course of national currencies
In the twenty-first century type of course determine the recommendations of the International Monetary Fund local Banks. The technique includes 10 algorithms to determine the cost of money, divided in three main modes:
- Fixed
- Transition
- Floating
In the first two cases the national currency is completely dependent on the actions of the Central Bank, which “sets the rules of the game”, tying the rate to a fixed basket usually consists of the Euro and the US dollar.
If the money of the country have the status of a freely convertible, their value is determined by the laws of supply and demand in the international currency market Forex, where it is compared to the U.S. dollar. The U.S. currency is set by the measure of the cost of any other national currency by the decision of the Jamaican G7 conference held in 1976.
Floating means that each party having access to the interbank market to buy or sell a currency in any amount, 24 hours a day except weekends, but it does not absolve her of the influence of the Central Bank.
The nominal and the real exchange rate of the national currency
The national Regulator openly manipulates the course in the interests of economy, understating its cost, the deficit of the trade balance, thereby helping exports and inflating with surplus to citizens and businesses can buy a larger quantity of imported goods.
In addition to these external factors controlling the flow of goods main Bank of any country is obliged to stimulate the domestic economy, to fight inflation, to provide affordable loans, etc. the Combination of these measures is called monetary policy (DCT), which determines the nominal exchange rate, often far from the real rating.
The nominal exchange rate of the national currency is the exchange rate of the Forex market for the floating regime currency free conversion or its cost in local currency exchange, limited kind of conditional corridor rates or defined in discrete mode of the auction.
The real exchange rate of the national currency determined its purchasing power abroad. Theoretically, it is calculated using a sample of identical items. It is enough to estimate, how much it costs a certain imaginary market basket at Home, and compare the amount spent in another country. Comparing final results in foreign and national currency, we get the real exchange rate, which does not always coincide with the nominal value.
This method is called determining the acceptability of consumer value, economic theory offers five models of definition of the real exchange rate of the national currency. Before diving into the theory and formulas, it is important to understand why we need this knowledge.
What you need to know the mode of determining the exchange rate and the real value of national currencies?
If a country has a fixed or a transition course definition of national currencies, a currency trader can determine entry point with a guaranteed profit. For example, the yuan exchange trading strictly “locked” in the corridor of 2%, which allows entering the maximum deviations, knowing exactly what’s coming intervention the people’s Bank. The features of such trade is described in our article about trading pair USDCNH.
Knowing the pricing regime, it is possible to determine the strategy of the inputs on the borders of the basket. Examples of trading such currency pairs with the help of the currency corridors is presented below.
Determining the real value of the national currency is a tool of the medium-term and long-term arbitrage strategies. As has been shown above, the Central Bank is hostage to the current economic situation: inflation, foreign trade turnover and balance of sanctions, the policy of the government, President, etc.
If a currency speculator has determined that there is a strong skew in nominal and real value, he may rely on the failure of monetary policy.
Despite the power of the Central Bank, the possibility of manipulation or artificial containment of the cost of the national currency is not limitless. Ultimately, the big players-arbitrageurs will reject quotes to the levels of “fair” or real value, and the misalignment can earn a decent profit.
The most striking example of this development is the opposition of George Soros and the Bank of England, who were mistaken in their ability to keep the binding of the pound sterling against the precursor to the Euro ECU.
Such collapses are rare, but in the medium term deviations often allow you to “catch” on future reversals or continuations of the trend for 400-600 points.
Trade on the borders of the nominal value of national currencies at fixed and transient modes
A list of exchange rates with fixed and transitional regimes available in the Russian version of Wikipedia where this subject is published in a separate article. In the list of tools Forex broker no many of is represented in this national currency because of the low liquidity and the lack of free convertibility of the exchange rate.
Checking the list of fixed and transitional courses are available in pairs with a broker, try to choose the national currency of the developed States with a stable economy. As an example, consider few currency pairs and principles of the arbitration work.
Danish Krone (DKK)
The national currency of Denmark is part of ERM – mechanism of the EU governing the unity of the exchange rate with the Euro. The crown cannot be above or below 15% of the value of the single currency within the corridor with a coefficient 7,46038:1. In reality, having studied the history of trading since the binding of 1 January 1999, the maximum deviation was not more than 1%.
These figures indicate options money management – the trader must provide the tensile strength of the Deposit to drawdown of 20%. Therefore, leverage the USDDKK pair should not exceed 1 to 5.
To provide a large amount of deals signal market entry to better identify when there is divergence of 0.25% of the EURDKK exchange rate at the close of the daily candle or during the session. Adding and subtracting this value from total binding 7,46038, the trader will receive a corridor bounded at the top and bottom levels and 7,48 7,44.
The direction input will determine the divergence and the position of the Danish kroner against the Euro. However, the trader should bear in mind that the Forex company there are only a couple USDDKK. If the course is DKK inflated, it is necessary to open long pair USDDKK (note the reverse quote), the value of the rate below 0.25 percent – an occasion to open shorts.
Not to hold every time calculations, you can use the visual method of determining differences using graphs EURDKK service TraidingView. As soon as the quotes will cross the signal line, go to the USDDKK chart.
To calculate the rate of Danish kroner in dollars, use the opposite quote of the Euro and the coefficient of binding. For example, at the beginning of the day on 24 may, the value of the Euro (counting the quote to the dollar!) Open Price amounted to 1/1,11799=0,8944. Knowing that the coefficient of binding is 7,46038, we define the nominal exchange rate DKK = 0,8944*7,46038 =6,6725.
Consider the example of entering a trade at the signal graphics TraidingView EURDKK. As you can see from the screenshot, 21 June the cost of the crown exceeded us a threshold value that gave a signal to sell DKK at the end of the session.
To accurately calculate the rate of USDDKK, we add to the graph line comparison EURUSD from the same data provider quotes EURDKK (in our case ICE). Please note that the pair was held with the EURUSD at 1.14.
Calculate the level of open long USDDKK 1/1,14 (EURUSD) = 0,87719*7,48290 = 6,5639. As can be seen from the graph Alpari, this level of quotations reached only after the weekend on June 24. Thus, our long was open late and brought a profit only on June 25.
UAE dirham (AED)
The pair USDAED the most simple to trade because of the very hard peg to the dollar, the national Bank kept the rate coefficient 3,6725 dirhams even in the crisis period of 2008.
The result is a graph of the national currency of the UAE looks like a series of candles with long tails above and below the limits which should place pending orders.
The picture graph shows weekly candles, where the first sight visible the possible levels of transactions, but in this trade there are nuances. First, there are only two broker, can provide access to a pair USDAED; secondly, they ask for a minimum Deposit of $10 000; third, maximum leverage on the currency is 1 to 5.
Definition model of the real exchange rate
In Forex market there is no single ideal model, 100% model the strong differences with the nominal value of the currency. Like all indicators, presents formulas require the test of history, with different accuracy suit for specific currency pairs, working in combination with each other. Therefore try to examine the main models and theories of the exchange rate.
The purchasing power of the national currency against any other currency is determined in four ways, which we will discuss below.
The law of one price – a cost comparison of the same product in different countries
The current price of goods in units of national currency = currency pair* the Current price of goods in foreign currency.
The most popular and well-known way to use this formula is the big Mac Index that compares the cost of a standard Burger from McDonald’s in different countries.
According to the specialized website a big Mac in Russia was worth in January 2019 130 rubles, whereas in the US the cost was of 5.58 USD.
130=66,91 (the rate of the Central Bank of the Russian Federation)* 5,58;
66,91=130/5,58 = 23,29.
The formula shows that the exchange rate of the national currency is undervalued or underestimated by more than two times. This difference almost coincides with the magnitude of the gap that formed in the “zero point” of reference – the opening of the first McDonald’s in Moscow. In a year of a world economic and political crisis.
In 2009, the gap between American and Russian price of the famous sandwich was reduced to 30%, but then began expanding, reaching in 2014 to 50.8%. We can assume that the current value of the big Mac index points to a new round of crisis phenomena in the economy. Enjoy the moment of “cheap dollar”, maybe on the strengthening of the ruble makes sense to increase the proportion of savings in that currency.
Absolute purchasing power parity
In the formula absolute parity is the price of one product is used the average price level of some of the same consumer baskets for different countries expressed in national currencies or the value of the subsistence minimum.
For example, in Australia cost at least AUD $ 600 in 2017, whereas in the EU it is equal to: in Germany – 1240 euros, in France – 1254, Italy – 855.
Euro – the common currency for 26 countries, so it selected the three largest EU economy, to use in the formula the average value (1240+1255+855)/3= 1117.
If 1117 – the average subsistence level of the EU, and 600 – the cost of living Australia, then solving this expression, we obtain 1117/600 =1,86.
In 2017, the rate of EURAUD to 1.38. As can be seen from the chart of the currency pair, arbitrage correctly predicted the trend in the strengthening of the Euro.
In 2019, the difference in the levels of the subsistence minimum was reduced to almost zero, so be careful of those who hold a long position on this cross.
Relative trading parity
Economists in their calculations using economic indicators showing the relative change in consumer prices. In the formula is substituted the difference between the current value of the indicator of the economic calendar and the previous data.
For example, the consumer price index in the United States in 2012 was equal 119,4 grew and by 2013 to 121. During this period, the CPI of the European Union showed values 118,3 120,1 and. The EURUSD rate has varied from 1.30 to 1.36.
Using the formula, calculate the real exchange rate of the Euro, taking value 2012 1.30 sequentially multiplied by the fraction of the relative values of the U.S. CPI 121/119,4 and the European 120,1/118,3:
1,3* (121/119,4) *(120,1/118,3) = 1,3374.
As can be seen from the formula, the Euro turned out to be underestimated, which led to the collapse of 2014, where parity has leveled off due to the efforts of the ECB and the fed measures of monetary character.
The consumer price index, essentially a measure of inflation, which is primarily oriented Central Banks when making decisions on the policy rate. Economic statistics rarely seen in the publication of this indicator in relative units, then there’s always the percentage change, which can also be used in another model.
Parity, relative inflation
When calculating the real value of the national currency against a currency of another country use some variation of the formula.
The current rate of the currency pair may be present is equal to (1+annual inflation one state/1+annual inflation of another country) * for the current pair in the Forex market.
We calculate the rate of EURUSD in 2015. At the end of this period, the US inflation rate stood at 0.73 per cent, whereas in the Eurozone it was equal to 0,08%.
The real exchange rate, EURUSD to the end of 2015= (1 +0,0083)/(1+0,073)*1,0565= 0,992.
Quotes EURUSD at the beginning of 2016 was understated, and increases in the rates policy adopted by the fed, not immediately saved the situation, since the market has seen a value close to 1.02, before the value of the European currency started to grow.
This formula can be used to predict of course, if it to substitute future inflation expected by the Central Banks in the published reports at each monthly meeting.
Conclusion
In the academic sense, the determination of the real value of the national currency is a difficult task, which used multi-factor models in econometrics and mathematical statistics. Central banks and institutional investors develop their own unique algorithms and approaches to assess and forecast the state of the economy in the relative coordinate system of currency trading.
However, any novice trader can with sufficient accuracy to assess the overbought or oversold foreign exchange rate using a simple mathematical structures based on actual current performance of the economy. Sometimes the resulting model will predict the future behaviour of the exchange rate rather than economic polynomials of Central Banks.
