What makes an FX cross cheap?
Valuing a currency is not easy. Here we will review some of the most common methods.
Valuation at its core is an exercise of comparing the price of a security with a measure of fundamental value. Think about stocks and earnings. But what can take the role of “earnings” for currencies?
Valuation against interest rates
In a sense, currencies do have earnings: the interest rate that you earn in that currency. By extension, the dividend of a cross between two currencies is the net interest rate.
Taking EURUSD as an example, you are long EUR and short USD - so you receive interest in EUR and pay it in USD. Assuming EUR has interest rates for 1M equal to 0.5% and USD has 1M interest rates equal to 3%, then your net interest rate in EURUSD is -2.5%.
If this interest rate differential were to rise, EUR would in theory appreciate, but why? The answer is that investors would find it more compelling to invest in EUR bonds than before and therefore demand for Euros would go up.
Using this as an anchor of fundamental value, we can begin to gauge value for a currency cross by means of a regression against its rates differential.
Let’s say that for any 1% of shift in rates, the cross goes up 3%. However recently, the rate differential went up 2% but the currency stayed flat. Then we can claim that the currency should be 6% higher - it is 6% undervalued!
Here is how this looks like:
Other methods of valuing a currency
Other methods include adjusting the currencies for purchasing power. Imagine an apple costs $1 in one country and $0.5 (after conversion) in another.
Clearly there’s an incentive for apple sellers to buy their apples in the latter country. To do this they first need to sell dollars to buy the currency of the latter country, thus bringing that currency upwards.
This method of valuation is defined purchasing power parity.