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Fundamental Analysis

Fundamental Analysis Primer

Fundamental analysis serves as a basic means to determine the future of a particular investment. It is based on using a variety of economic and political indicators tied to the particular security to determine whether the security is a viable investment. The fundamental assumption of a fundamental analysis is that, while prices are the most important factor surrounding an investment, prices do not respond immediately to market factors. The lack of immediate price adjustment leads investors to analyze market factors to capitalize on artificial price levels before they move.

Example of How Fundamentals Move the Forex Market

Let us look at an extended example of how fundamental analysis might impact a particular set of trades in the forex market. Suppose that an investor learns two pieces of news coming from Japan: (1) GDP growth for the current fiscal year is expected to rise, and (2) the national military just invested 100 billion JPY (Japanese Yen) in weaponry. Respectively, we see that these economic and political changes and outcomes would result positively in the demand for Japanese currency. Larger than expected, GDP growth means that the Japanese economy will be producing more goods and services that domestic demand is expected. This will lead to an increase in both inventories and in foreign demand for Japanese goods. Consequently, foreign consumers will need more JPY in order to buy those extra, unexpected Japanese goods.

While the economic news convey clear ramifications, so does the political information. The remark that Japan increased investment in its military affects demand for JPY in two ways. The first direct effect is that increasing demand for weaponry increases total capital investment, thereby increasing aggregate demand. The increase in aggregate demand requires JPY in order to facilitate the increased number of transactions.

There is another, more indirect, subjective manner by which the demand for JPY goes up. The increase in military investment paints a picture of Japan as a country committed to its security and stability. Political stability in a nation fuels desire for all investors (both domestic and foreign) to invest in that economy because of the feeling that those investments would be more secure than analogous investments in a more politically unstable country.

Returning to the original forex investor, the fundamental analysis above hints that, holding other things equal, the Japanese Yen will be valued higher than the U.S. Dollar. Sensing this trend, the forex investor would want to exchange USD for JPY. Economic and political news can have the reverse effect as well. Suppose that after a month into the initial investment, the forex investor learns that: (1) the inflation rate in Japan is recorded at a higher-than-expected level for the fiscal year and (2) political rioting breaks out in Tokyo in response to unpopular government legislation.

It is clear that these are negative pieces of news that would negatively impact faith in the Japanese yen. (We will leave the exact formulation of this fundamental analysis to the reader). The forex trader would undoubtedly want to get his assets out of JPY and back into USD. It must be noted that in this example, we focused on macroeconomic and political indicators since we were dealing with forex trading. Yet, fundamental analysis by its definition can involve the study of any economic or financial information. By contrast, suppose an investor is interested in investing in a publicly traded company. Fundamental analysis might arise from studying data such as company profit flows or company management ratings.

With all that in mind, fundamental analysis is an effective way of studying the performance of a certain investment in the future. As you can see, by our example of the value of the Japanese Yen, we can determine that political and economic outcomes deeply affect the performance of a particular sect of the market. Therefore it is beneficial that when engaging in fundamental analysis, that you do your homework and keep up to date with the latest news in both the economic and political realm. Some people may find it useful to read the newspaper, surf the web for the latest breaking news, or even find useful tools like an economic calendar (like the one shown above). After all that is said and done, you just might realize that fundamental analysis is a useful practice.