The factors that affect the FOREX market are mainly political and economic. Economies of different countries develop in a cyclical fashion (upturns and depressions), and the cycles do not often coincide. Market participants carefully analyze these processes. They analyze data on inflation, trade balances, output and many other indicators. This is called fundamental analysis.
One factor affecting exchange rates between two countries is the trade balance. By definition, the merchandise trade balance is the net difference between the value of merchandise being exported and imported into a particular country. For example, consider the exchange rate for Euros against US dollars. The United States imports products from Europe. To pay for them, Americans need Euros; therefore, the U.S. companies trade the U.S. dollar for Euros. On the other hand, because Europeans desire American-made goods, they purchase U.S. dollars to pay for U.S. goods. The American demand for European goods and services contributes to the demand for Euros while European purchases of American goods and services contribute to the demand of U.S. dollars. In this case, the net difference between American purchases of European goods and services, and European purchases of American goods and services, is the merchandise trade balance between the two countries.
In the near term, these capital flows are greatly influenced by yield differentials. All else being equal, the higher the yield on European securities compared to American securities, the more attractive European securities are relative to American securities. An increase in European yields would tend to raise the flow of U.S. dollars into European securities as well as decrease the outflow of Euros to American securities. Combined, this increased flow of funds into Europe would lower the value of the U.S. dollar and increase the value of the Euro; therefore, the Euro to U.S. dollar ("EUR/USD") ratio, as it is represented in the FOREX market, would increase.
The rate of inflation is another factor influencing currency exchange rates. The currency from the lower inflation country rises in value, while the currency from the higher inflation country falls in value. Both the inflation factor and the purchasing power of the currencies directly impact currency exchange rates.
Another type of analysis used in foreign currency trading (as well as many other financial markets) is technical analysis. Price graphs are used in this analysis.
