Fair value strategies in forex markets (part two)
The fair value forex trading strategy aims to assign a value to currencies based on the strenght of their economies. It is used to compare the performance of economies in order to take decisions on relative currency pairs. After having analysed the most important sectors of the two economies, according to the importance each sector has, each sector is given points based on its performance and importance, and the performance points for each sector are then multiplied. Finally, all the sectors are added together.
The total weight of all the components should be the same for both economies, in order to have a balance. For example, if the manufacturing sector in Switzerland only accounts for 1 out of the total 10 points in real weight, the service sector will have to compensate it. So, the real total weight for both economies is 10.
After this operation has been made, a trader observe how each sector is performing and rate it from 1 to 5, based on the performance and the trends observed over the last months. Then, a trader must multiply the weight of each sector with its performance to get the total points and then add the points of all the sectors to get the score of the entire economy. In the evaluation process, he/she can use also other economic variables, such as inflation rate, public debt, trade balance, etc. For instance, the oil price is very important for Norway’s economy, so this should definitely be included in the analysis to evaluate the performance of the Norwegian economy.
After evaluating which economy is performing better a trader can either trade the short-term or the mid-term scenario, exploiting the most used and preferred forex strategies, for istance Bollinger bands, channels and so on. Ususally, the short-term ranges from a few months to 2 years, while the mid-term from 2 years to 10 years.
The fair value is one of the most preferred strategies by hedge funds, pension funds, and investment banks. The strategy is particularly efficient for large positions but it requires to reevaluate the performance of economies often, because the weigh of the sectors can change over time.