If currency markets could be solved by a single modeling approach, none of us could make any money trading them. After all, if each of us could solve a single equation exactly, we would all be on the winning side of every trade. This would be like trying to trade the law of gravity, or some other system with an exact solution.
This leaves us with the uneasy (and unpopular) conclusion that losing traders are the necessary bottom of the food chain each day. These losers pay the winners, and like Las Vegas, the winners pay the house. Without an endless supply of grim suckers ready, willing, and able to keep the game going, it would collapse.
But fear not. Not only is everyone reading this an above average trader, we can rest assured there never will be a single modeling approach to the currency markets.
Mathematically, the currency system lacks a “closedform” solution. Not only does the basic interest-rate arbitrage equation have three unknowns (two interest rates and a spot exchange rate) that preclude a single solution, but numerous other factors enter into the mix as well: capital flows, global yield curves, commodity prices, political risks, and returns on assets.
These non-interest-rate factors often are more visible in the minor currencies, which can be buffeted about more readily than the majors. Let’s use the Mexican peso (MXN) as a case study.
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