by Exchange Rate Forecasts are derived by the computation of value of vis-à-vis other foreign currencies for a definite time period. There are numerous theories to predict exchange rates, but all of them have their own limitations.
Economists and investors always tend to forecast the future exchange rates so that they can depend on the predictions to derive monetary value. There are different models that are used to find out the future exchange rate of a currency.
Efficient Market Approach
Financial markets are said to be efficient if the current asset prices fully reflect all the available and relevant information (efficient market hypothesis).
Suppose that foreign exchange markets are efficient. This means that the current exchange rate has already reflected all relevant information, such as money supplies, inflation rates, trade balances, and output growth. The exchange rate will then change only when the market receives new information. News is unpredictable, the exchange rate will change randomly over time. -Incremental changes in the exchange rate will be independent of the past history of the exchange rate. If the exchange rate indeed follows a random walk, the future exchange rate is expected to be the same as the current exchange rate.
Random walk hypothesis suggests that today’s exchange rate is the best predictor of tomorrow’s exchange rate.
Those who subscribe to the efficient market hypothesis may predict the future exchange rate using either the current spot exchange rate or the current forward exchange rate.
Advantages:
Since the efficient market approach is based on market-determined prices, it is costless to generate forecasts. Both the current spot and forward exchange rates are public information. Everyone has free access to it.
Given the efficiency of foreign exchange markets, it is difficult to outperform the market-based forecasts unless the forecaster has access to private information that is not yet reflected in the current exchange rate.
Fundamental Approach
This is a forecasting technique that utilizes elementary data related to a country, such as GDP, inflation rates, productivity, balance of trade, and unemployment rate. The principle is that the ‘True worth’ of a currency will eventually be realized at some point of time. This approach is suitable for long-term investments.
- Relative Money supplies
- Relative Velocity of monies
- Relative National outputs
Steps
- Estimation of the structural model to determine the numerical values for the parameters such as betas.
- Estimation of future values of the independent variables.
- Substituting the estimated values of the independent variable into the estimated structural model to generate the exchange rate forecasts.
Technical Approach
In this approach, the investor sentiment determines the changes in the exchange rate. It makes predictions by making a chart of the patterns. In addition, positioning surveys, moving-average trend-seeking trade rules, and Forex dealers’ customer-flow data are used in this approach.
Performance of the Forecasters
Time Series Model
The time series model is completely technical and does not include any economic theory. The popular time series approach is known as the autoregressive moving average (ARMA) process.
The rationale is that the past behavior and price patterns can affect the future price behavior and patterns. The data used in this approach is just the time series of data to use the selected parameters to create a workable model.
To conclude, forecasting the exchange rate is an ardent task and that is why many companies and investors just tend to hedge the currency risk. Still, some people believe in forecasting exchange rates and try to find the factors that affect currency-rate movements. For them, the approaches mentioned above are a good point to start with.
Relative Economic Strength Model
The relative economic strength model determines the direction of exchange rates by taking into consideration the strength of economic growth in different countries. The idea behind this approach is that a strong economic growth will attract more investments from foreign investors. To purchase these investments in a particular country, the investor will buy the country’s currency – increasing the demand and price (appreciation) of the currency of that particular country.
Another factor bringing investors to a country is its interest rates. High interest rates will attract more investors, and the demand for that currency will increase, which would let the currency to appreciate.
Conversely, low interest rates will do the opposite and investors will shy away from investment in a particular country. The investors may even borrow that country’s low-priced currency to fund other investments. This was the case when the Japanese yen interest rates were extremely low. This is commonly called carry-trade strategy.
The relative economic strength approach does not exactly forecast the future exchange rate like the PPP approach. It just tells whether a currency is going to appreciate or depreciate.
Purchasing Power Parity Model
The purchasing power parity (PPP) forecasting approach is based on the Law of One Price. It states that same goods in different countries should have identical prices. For example, this law argues that a chalk in Australia will have the same price as a chalk of equal dimensions in the U.S. (considering the exchange rate and excluding transaction and shipping costs). That is, there will be no arbitrage opportunity to buy cheap in one count Econometric Models
It is a method that is used to forecast exchange rates by gathering all relevant factors that may affect a certain currency. It connects all these factors to forecast the exchange rate. The factors are normally from economic theory, but any variable can be added to it if required.
For example, say, a forecaster for a Canadian company has researched factors he thinks would affect the USD/CAD exchange rate. From his research and analysis, he found that the most influential factors are: the interest rate differential (INT), the GDP growth rate differences (GDP), and the income growth rate (IGR) differences.
The econometric model he comes up with is:
USD/CAD (1 year) = z + a(INT) + b(GDP) + c(IGR)
Now, using this model, the variables mentioned, i.e., INT, GDP, and IGR can be used to generate a forecast. The coefficients used (a, b, and c) will affect the exchange rate and will determine its direction (positive or negative).ry and sell at a profit in another.
