Fair value trading in the stocks market is based on the total company value, including its machinery, buildings, capital, financial instruments, the interest that others owe to the company, and the company’s total debt and corresponding debt. This is the general definition of fair value. The trading done using this information is called fair value trading.
It is a part of many financial markets, especially futures and stocks. In the futures markets, the equilibrium between a futures spot price and the expected interest on it is considered to be the fair value. Futures are bought and sold if the traders see a difference between the two and the gap is expected to close. In the stocks market as well, shares are sold and bought using the fair value strategy. Traders and investors calculate the real value of the company by evaluating its entire components. This value is then divided by the number of shares that the company is offering to check if the stocks are accurately or fairly priced by the market.
FX Fair Value definition
FX fair value or currency fair value represents the value of a currency based on the economic shape of a country and it is not the same as market value. The currency market rate is a value that is more volatile because currency price reacts to changes in demand and short time news.FX fair value trading strategies are based on undervalued and overvalued currency pairs.
If the market fx value is lower than the fair value than currency is undervalued.
If the market fx value is higher than the fair value than currency is overvalued.
FX fair value strategy claims that undervalued currency should be bought and the overvalued currency should be sold in the hope that the exchange rate should move in that direction.
FX Fair Value Trading Strategies
Using the fair value for trading in stocks and futures is common but it is used in other markets as well, especially in Forex. If you are a Forex trader and you are wondering why you don’t know about this strategy, it might be because you have been using it all along without noticing.
To find out the FX fair value, traders need to focus on the economic condition of the country. It is a known fact that the value of a currency depends largely on the condition of its country. The same rule is followed here. To estimate the value of the country might seem like a mammoth task but it is actually very easy. This is also known as fundamental analysis. You collect data from the country’s official websites, keep a tab of the news, and also look for political stability. All of these factors affect the value of the currency. Traders compare countries for both short-term (2 years) and medium-term (7-8 years).
FX Fair Value Trading Strategy example:
OECD Purchasing Power Parity defines the fair value of the currency. Go to OECD Purchasing Power Parity page and pick several currency countries that you like to trade. Find 3 currency most undervalued (lowest PPP fair value figure) and find 3 currency most overvalued (highest PPP fair value figure).
Buy undervalued currency, sell overvalued currency.
For example, if EUR has the lowest PPP fair value figure and GBP has the highest PPP fair value figure you can BUY EURGBP.
You can make any combination that you like. This kind of strategy usually has a time duration of at least one 1 month.
Application if FX Fair Value Trading Strategies
Forex trading is done with a pair of currency, like EUR/USD, USD/JPY, etc. The first currency is the base currency and the second one is your counter currency.
As we mentioned earlier, it would be difficult for you to make reasonable profits in the Forex trading market without doing some level of fundamental analysis. You don’t have to dive into the pile of papers released by the government of a country but you must be aware of some basics like the growth in GDP of both the countries, how persistent is the unemployment rate, and the inflation rate as well. There are other aspects as well like infrastructural development, the rate of interest, education, and more but these three are more important as they have a somewhat direct impact on the value of the currency. Focus on both countries. You can obtain this data from government websites, in the newspapers, and on your broker’s trading platform.
Refer to the following example for a better understanding of how the economic data affects the FX fair value:
If our currency pair is EUR/GBP, we are comparing the United Kingdom to the Eurozone. In this case, European manufacturing will secure 10 points but the UK will only get 2 or 3 points in this department. This is because manufacturing is not as important in the UK as in other large European countries. It makes barely 10% of the UK’s GDP. If we move to the service sector, the UK will get more points as compared to the rest of the Eurozone because it is an important sector here.
Similarly, we will refer to GDP and other economic criteria to give points to both countries. The two economics are ranked on the basis of how important a sector is for the respective economy. The next step is to calculate how well the sectors of these economies have performed.
Since the global financial crises of 2008, the economy of the Uk has been better than the Eurozone. If you had used FX Fair value as the base of your trading strategies since 2008, you would have made a profit of at least 3,000 pips till now.
This was a broader example. There are other factors that show the strength of the economy like wage inflation, trade balance, spending, productivity, saving, etc. For example, the global dairy price becomes an important factor when you are evaluating the economy of New Zealand.
Once you have calculated how the economies are performing, you can go for either short-term or mid-term trade. If you are choosing the first option, focus on the macroeconomics indicators for a period of 1 month to up to 2 years. For the mid-term trading strategy, the time period to be considered should not be less than 2 years and it can go up to 10 years. The mid-term trading strategy is not popular among retail traders. Generally, hedge funds, investment banks, and pension funds use it.
FX fair value trading strategies are crucial in long-term trading as well. Your strategy will remain the same in the long-term as well with just one change, you need to re-evaluate the position of the economies after every couple of months.