Pricing And Valuation of Currency- Impact of CAD and Commodities

INVESTING IN FOREX MARKETS ? A PRIMER

-By Ajay Krishnan, Knowledge Partner EZ Wealth

You know that the price of a stock goes up when the company creates value and goes down when it doesn?t. But what about the actual price of the share? I?m sure if you have been following the equity market, you know that share prices are determined by a variety of factors like supply and demand, market capitalization, earnings reports, earnings per share, a valuation multiple (like the P/E ratio) etc. In an IPO, the shares are valued and priced according to the shares outstanding (shares available to the general public) and market capitalization by an underwriter (an investment bank usually). Once it is in the secondary market, all the previous factors that I mentioned comes into play. The stock prices move up or down depending on these factors as well as news announcements, political developments and global cues (for large caps especially).

??????????????????????????????? Fig 1. Movement in stock price of RIL with a higher forward P/E

How about currencies?

Of course, there are no IPOs for currencies and no P/E ratios or EPS to go by to value them. The price movements of currencies are also not dependent on factors that are attributable to one single entity, like a stock company. So how do we value them and factor in their prices? Let?s study two of the most important factors responsible for this.

Current Account Deficit and Exposure to Commodities

We learned that the currency of a country is linked to the strength of its economy. Better the economic indicators, better the value of the currency. But the major catalyst for this is the position of a country?s current account deficit (CAD) ? which is how much money it owes to other countries.

Fig 2. Trade balances of major economical regions

CAD is easy to understand. If you import more goods and services than you export, then you have a trade deficit. If you export more than your import bill, then you have a trade surplus. Put into other words, if more people want to buy stuff from you then their money is coming into your account and you are getting richer. Similarly, when you have to buy stuff from others your money goes into their accounts and you get poorer. In the latter, at a certain point your account goes into a loss ? and that is when you have a current account deficit (CAD). And if you do, then your economy?s value comes down along with your currency. Higher the deficit, lower your currency goes. Similarly, when you have a current account surplus, your currency tends to do better. This seems like common sense, right?

This is the simplest way to understand CAD.

As you may have guessed, India doesn?t really stand tall when it comes to handling its CAD. We have had a considerable deficit for all the years after liberalisation except for two years with a tiny surplus.

Fig 3. Chart showing the relationship between INR and India?s Current Account Deficit

Hence, we see that current account deficit of a country is a major factor in determining a currency?s price (value).

The second important reason that affect currency prices is exposure to commodities.

A considerable amount of world trade is concentrated on commodities (or goods) like crude oil, copper, wheat, rubber, steel, silicone etc. So, the more exposed (or dependent on) a currency is to certain commodities, the more its currency is influenced by changes in the value of those commodities. For example, since Japan is heavily dependent on its electronics exports, any rise in value of silicone (for making computer chips) will affect them badly ? thus hitting its economy and its currency, the Japanese Yen.

Now out of all the commodities traded globally, crude oil takes up a staggering 68.8% of global consumption. One the major economies that is heavily dependent on crude oil imports is India. This is the reason why INR?s value tends to fall when there is a surge in crude oil prices, because India is so exposed to that commodity – 70% of our total imports consist of crude oil. Similarly, it tends to perform better when crude oil prices are lower. This is shown below:

Fig 4. Graph showing the relation between crude oil prices and INR exchange rate

Now that we have understood two of the most fundamental factors affecting currency prices, we are now ready to explore the third factor that influences a country?s currency: Central Bank Interest rates. Once we are thorough with these, we can explore trading signals and strategies.

?Next: Interest Rate Expectations and Currency Prices

Disclaimer: It is only for educational purpose. The information is collected from various published sources. You are advised to consult your financial advisors before taking any decision.In no case Wealth Discovery Securities or Ezwealth will be responsible or cannot be liable for any loss on your action taken.