Understanding Fair Value of Emerging Market FX Rates

FX_IDC:EURBRL   Euro / Brazilian Real
When making the decision of when to convert currency people tend to have a short-sighted view of what good value exchange rates are. What most people don't take into account are the 4 most important factors when it comes to a currency: Inflation, Interest Rates, Economic Health, Political Risk.

Inflation is the first aspect to look at. Typically a currency will stay in a range whilst inflation continues to increase asset prices and eventually the currency breaks out of the range to establish a new range. At the moment of the breakout, everyone thinks it is temporary and will go back down and that it is too expensive or overvalued when in reality it is just the currency finally catching up to a fairer range inline with inflation over the period. This repeats itself over and over again.

Typically a currency goes sideways whilst inflation and other fundamentals deteriorate its value over time. In reality, currencies should gradually depreciate in a stairway or step by step pattern. Eventually, the currency moves through its fair value trend to become over/undervalued and then accelerates dramatically to catch up to its true value. These moments of acceleration are often exaggerated to a peak before pulling back to fair value and then going sideways again.

If you add a reducing interest rate, weak economic health and political risks you can expect the currency to depreciate further than the longer-term inflation average as foreign investors do not want to own a risky currency that offers low-interest rates.

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