based on the expected cash flows potentially generated by the asset – dividends, coupons, selling price, etc. This approach is more broadly accepted by the market practice, rather then the accounting approach evaluating the company’s total assets and liabilities, but failing to appropriately take into account such intangible assets like trade marks or customers’ loyalty.
Foreign exchange market is somewhat different in this respect. The value of currency does reflect the state of the country economy. Unlike a company, the country cannot be priced in terms of assets and liabilities. Money however generate quite easily definable cash flow in except that this flow is in the same units – same currency.
It is however possible to use one currency, e.g. USD, as reference currency
to evaluate the exchange rates and interest rates of another currency, say
EUR. Thus, if investing from USD into EUR now, holding EUR for one period
of time, then converting the investment amount back into USD, generates
more income then the interest rates on the USD, then EUR can be considered
as underevaluated relative to the USD, and such an investment strategy
should be followed.
In practice, there are considerations that often prevent from profitable
using this investment strategy:
The Interest Rate Parity, which states that
where iA and iB are interest rates on currencies A and B respectively,
rp,AB is the present exchange rate, rf,AB is the forward exchange rate,
Even if, as shown in the chapter 4, the relationship above does not
hold, the trading costs will almost surely reach the level or even exceed
the potential profit.