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What is factor modeling in forex risk management?

Factor models decompose currency risk into underlying drivers like interest rate spreads, commodity prices, or global risk sentiment. Example: AUD/USD can be modeled as influenced by U.S.-Australia yield differentials, iron ore prices, and risk-on/risk-off flows. Institutions use factor models to stress-test portfolios, design hedges, and detect hidden exposures. Benefits: clarity, improved diversification, and predictive insight. Risks: factors may shift over time, and models can oversimplify reality. Retail traders can approximate factor models by tracking key economic indicators tied to currencies. Factor modeling highlights that forex prices are not random—they reflect identifiable economic and financial forces that can be measured and managed.