Let us take a look at a thorough example of how fundamental analysis influences a specific series of trades in a forex market.
Imagine that investors receive two news from Japan:
1st – GDP is expected to grow during the current fiscal year.
2nd – the national Japanese army invested 100 billion JPY (Japanese Yen) in new weapons.
We know that both economic and political news can influence positively the demand for Japanese currency. Higher than expected, GDP growth also means that the economy has produced more goods or services. This leads to an increase in national inventories or an increase in foreign demand for goods. Japanese currency will soar in consequence of this higher demand. Foreign consumers and companies need more JPY in their pockets to buy those Japanese goods and services that provoked the GDP growth.
While these economic news imply simple ramifications, the same is the case with political information. The news about increased investment in Japan military pushes demand for JPY. The news affects the currency price in two basic ways. The first effect is of increasing demand for weapons and other military material. The total capital investment is higher, therefore it increases demand. The increase in demand implies more traders buying JPY to facilitate the higher number of forex transactions.
There is another way these news affect the currency exchange. This one is a more subtle process. The increase in defense investment implies that Japan is a country able to invest huge amounts of money in its security. Political stability means that most investors (domestic or international) will invest in its economy due to the feeling that their investments are more secure than equivalent investments in a less stable country.
Returning to the forex investor that we dealt with at the first place, the fundamental analysis hints that the Japanese Yen will be traded higher than the other currencies, like the Euro or U.S. Dollar. This trend, if perceived right, will allow the forex investor to exchange his USD account for a JPY account. Economic or political news sometimes have the reverse effect. Imagine that after some time into the investment, the forex investor knows that: 1st the inflation rate is recorded at a much higher than common level for the current fiscal year or 2nd political riots in Tokyo are increasingly more violent due to radical government legislation. In these cases, traders should expect the JPY to fall.
It is relatively simple to recognize negative news that negatively impact the Japanese yen. The forex trader can undoubtedly get his investment out of JPY balance and back into his USD balance.
In this example, we analyzed the macroeconomic or political aspects since we were analyzing forex trading. However, fundamental analysis can involve the study of economic and financial information, balance sheets or any other kind of news like tragedies, tsunamis or earthquakes. In a fundamental analysis you should simply consider everything that can affect the performance of a company. Imagine an investor interested in a publicly traded company, that gets constant news exposure. Fundamental analysis needs to study all data starting with company profit flows and company management ratings, not only its balance sheets.