In our last lesson we continued our free forex trading course with a look at how trade flows are measured through something known as the current account. In today's lesson we are going to switch back to the capital flows side of the equation with a look at how these are measured through what is known as the capital account.
The basic formula for calculating the capital account is: Increase in Foreign Ownership of Domestic Assets (things such as real estate, cross boarder M&A, and Investments by Foreign Companies in local operations) - Increase in Domestic Ownership of Foreign Assets Portfolio Investment (things such as stocks and bonds) Other Investment (things such as loans and bank accounts).
As with the current account it is for our purposes not important to understand all the intricate details of the capital account, but simply that where the current account measures money flowing in and out of a country as a result of trade flows, the capital account measures money flowing in and out of the country as a result of capital flows.
As we discussed in our lesson on capital flows, when a market in a country is outperforming the markets in other areas of the world, money will flow into the country from foreigners seeking to participate in those out sized returns. These capital flows are reflected in the country's capital account. This is the case whether we are talking about a country's stock market, bond market, real estate market etc.
As a quick example lets say that a mutual fund located in the United States invests $1 Million Dollars in the Canadian Stock Market, and a Canadian real estate firm buys the equivalent amount of real estate in the United states. Just for simplicities sake, if these were the only transactions that took place between these two countries and any other country, the Capital Account for both the United States and Canada would show a balance of zero, as the two transactions would have exactly offset themselves.
As with the current account when a country sees strong inflows or outflows of capital, this has a direct affect on its currency. When there are significant inflows this creates demand for the currency, pushing the value of the currency up, all else being equal. Conversely, when there are significant outflows, this creates a market supply of the currency, pushing its value down all else being equal.
As you may be able to tell by now, it is the interaction of both the current account and the capital account that fundamental traders focus on, as it is the imbalances here that theoretically cause the value of a currency to rise and fall over the long term. This will be the topic of our next lesson so we hope to see you then.
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