3 Traditional Ways of Forecasting Exchange Rates

Using currency exchange rates forecasts will help brokers and businesses make informed choices to help mitigate risks and optimize returns. There are several ways of estimating currency exchange rates. Here, we’ll look at some of the most common methods: purchasing power parity, relative economic strength, and econometric models.

Purchasing Power Parity ( PPP) is probably the most common form of indoctrination in most economic textbooks. The PPP forecasting approach is based on the theoretical one-price theorem, which states that similar goods in different countries should have the same prices.

TAKEAWAYS KEY

• Currency exchange rate forecasts help traders and companies to make better choices.
• Purchasing power parity looks at the prices of goods in different countries and is one of the most widely used methods for predicting exchange rates due to its indoctrination in textbooks.
• The method of relative economic strength compares the level of economic growth across countries to the projection of exchange rates.
• Finally, econometric models can consider a wide range of variables when trying to understand trends in currency markets.

According to purchasing power parity, the price of a pencil in Canada should be the same as that of a pencil in the United States, taking into account the exchange rate and excluding transaction and shipping costs. In other words, there should be no unfair incentive for someone to buy cheap pencils in one country and sell them to another for profit.

The PPP approach predicts that the exchange rate will change to compensate for price changes due to inflation on the basis of this underlying principle. Suppose, for example, that pencil prices in the U.S. are expected to increase by 4% over the next year, while prices in Canada are expected to rise by only 2%. The inflation gap between the two countries is as follows:

\begin{aligned} & 4\%-2\%=2\% \\end{aligned}

4 percent – 2 percent = 2 percent

This means that US pencil prices are expected to rise faster compared to Canadian prices. In this case, the purchasing power parity strategy will assume that the US dollar would have to depreciate by around 2% in order to keep the price of the pencil between the two countries reasonably equal. Thus, if the current exchange rate was 90 cents U.S. per one Canadian dollar, the PPP would have expected an exchange rate of:

\begin{aligned} & (1 + 0.02) \times (\text{US \$}0.90 \text {per CA \$}1) = \text{US \$}0.92 \text {per CA \$}1 \ end{aligned}

(1 + 0.02)×(US$0.90 per CA$)=US$0.92 per CA$1.

One of the most well-known applications of the PPP method is the Big Mac Index compiled and written by The Economist. This light-hearted index attempts to measure whether the currency is undervalued or overvalued on the basis of the price of the Big Macs in different countries. Since the Big Macs are almost universal in all the countries sold, the price comparison serves as the basis for the index1.

Relative strength of the economy

As the name suggests, the approach to relative economic strength. Looks at the pace of economic growth in different countries in order to predict the path of exchange rates. The rationale behind this approach is that a stable economic environment and potentially high growth are more likely to attract investment from foreign investors. And, to purchase an investment in the desired country, the investor would have to purchase the currency of the country; creating an increase in demand that would cause the currency to appreciate.

This approach is not just about the relative economic strength between countries. It takes a more general view and looks at all of the investment flows. For example, interest rates are another factor that can attract investors to a particular country. High-interest rates would attract investors looking for the best return on their investments, leading to an increase in the demand for the currency, which would again lead to currency appreciation.

Conversely, low-interest rates can also sometimes lead investors to avoid investing in a particular country or even borrow the country’s currency at low-interest rates to fund other investments. Many investors did this with the Japanese yen when Japan’s interest rates were at record lows. This strategy is commonly known as the carry trade.

Unlike the PPP approach, the relative economic strength method does not estimate what the exchange rate should be. Actually, this approach gives the investor a general sense of whether the currency can rise or depreciate. As well as a general sense of the speed of the change. Usually, it is used in conjunction with other forecasting methods to produce a complete result.

Econometric methods of forecasting of exchange rates

Another common method used to predict exchange rates involves collecting factors that could affect currency movements and constructing a model that links these variables to the exchange rate. The variables used in econometric models are usually focused on economic theory. Although any variable may be included if it is assumed to have a major effect on the exchange rate.

Suppose, that a forecaster for a Canadian corporation has been charged with forecasting the USD/CAD exchange rate for the next year. They agree that an econometric model would be a reasonable way to use it. And they have studied variables that they think to influence the exchange rate. They conclude from their study and review that the most important variables are; The difference in interest rates between the U.S. and Canada (INT). The difference in GDP growth rates (GDP), and the difference in income growth rates (IGR) between the two countries. The econometric model they generate is shown as:

\begin{aligned} & \text{USD / Cad(1-year)} = z + a(\text{INT}) + b(\text{GDP}) + c(\text{IGR}) \&\textbf{where:} \&\z = \text{Constant baseline exchange rate} \&a, b \text{and} c = \text{Coefficients representing relative} \\&\text{weight of each factor} \&\text{INT} = \text{Difference in interest rates between} \\&\text{U.S. \&\text{GDP} = \text{Difference in GDP growth rates} \&\text{IGR} = \text{Difference in income growth rates} \\end{aligned}

Where to:
z = Constant basic exchange rate
A, b and c= Relative coefficients
The mass of each element
INT = Difference of interest rates between
GDP = Difference in GDP growth rate
IGR = Difference in the rate of income growth

After the model develops, the variables INT, GDP, and IGR can be plugged in to produce the forecast. The coefficients a, b, and c will decide how much the exchange rate and the direction of the effect (whether positive or negative) are influenced by a certain factor. This method is probably the most complicated and time-consuming approach. But once the model develops, new data can be easily acquired and plugged into to produce fast forecasts.

Currency forecasting is a very difficult job, and that is why many businesses and investors simply hedge their currency risk. However, those who see value in forecasting exchange rates and want to understand the factors that influence their movements can use these methods as a good place to start their study.

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