4 ways to forecast currency changes _ investopedia

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5/28/2016 4 Ways To Forecast Currency Changes | Investopedia

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4 Ways To Forecast Currency Changes Ways To Forecast Currency Changes

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Many entities have an interest in being able to forecast the direction of exchange rates.any entities have an interest in being able to forecast the direction of exchange rates.

Whether you are a business or a trader, having an exchange rate forecast to guide yourhether you are a business or a trader, having an exchange rate forecast to guide your

decision making can be very important to minimize risks and maximize returns.ecision making can be very important to minimize risks and maximize returns.

TUTORIAL:UTORIAL: Economic Indicators To Knowconomic Indicators To Know

There are numerous methods of forecasting exchange rates, likely because none of them havehere are numerous methods of forecasting exchange rates, likely because none of them have

been shown to be superior to any other. This speaks to the difficulty of generating a qualityeen shown to be superior to any other. This speaks to the difficulty of generating a quality

forecast. However, this article will introduce you to four of the most popular methods fororecast. However, this article will introduce you to four of the most popular methods for

forecasting exchange rates.orecasting exchange rates.

Purchasing Power Parity (PPP)urchasing Power Parity (PPP)

Thehe purchasing power parityurchasing power parity (PPP) is perhaps the most popular method due to its(PPP) is perhaps the most popular method due to its

indoctrination in most economic textbooks. The PPP forecasting approach is based off of thendoctrination in most economic textbooks. The PPP forecasting approach is based off of the

theoretical Law of One Price, which states that identical goods in different countries shouldheoretical Law of One Price, which states that identical goods in different countries should

have identical prices.ave identical prices.

For example, this law argues that a pencil in Canada should be the same price as a pencil in theor example, this law argues that a pencil in Canada should be the same price as a pencil in the

U.S. after taking into account the exchange rate and excluding transaction and shipping costs..S. after taking into account the exchange rate and excluding transaction and shipping costs.

In other words, there should be no arbitrage opportunity for someone to buy pencils cheap inn other words, there should be no arbitrage opportunity for someone to buy pencils cheap in

one country and sell them in another for a profit.ne country and sell them in another for a profit.

Based on this underlying principle, the PPP approach forecasts that the exchange rate willased on this underlying principle, the PPP approach forecasts that the exchange rate will

change to offset price changes due to inflation. For example, suppose that prices in the U.S. arehange to offset price changes due to inflation. For example, suppose that prices in the U.S. are

expected to increase by 4% over the next year while prices in Canada are expected to rise byxpected to increase by 4% over the next year while prices in Canada are expected to rise by

only 2%. The inflation differential between the two countries is:nly 2%. The inflation differential between the two countries is:

4% - 2% = 2%% - 2% = 2%

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This means that prices in the U.S. are expected to rise faster relative to prices in Canada. Inhis means that prices in the U.S. are expected to rise faster relative to prices in Canada. In

this situation, the purchasing power parity approach would forecast that the U.S. dollar wouldhis situation, the purchasing power parity approach would forecast that the U.S. dollar would

have to depreciate by approximately 2% to keep prices between both countries relativelyave to depreciate by approximately 2% to keep prices between both countries relatively

equal. So, if the current exchange rate was 90 cents U.S. per one Canadian dollar, then the PPPqual. So, if the current exchange rate was 90 cents U.S. per one Canadian dollar, then the PPP

would forecast an exchange rate of:ould forecast an exchange rate of:

(1 + 0.02) x (US$0.90 per CA$1) = US$0.918 per CA$11 + 0.02) x (US$0.90 per CA$1) = US$0.918 per CA$1

Meaning it would now take 91.8 cents U.S. to buy one Canadian dollar.eaning it would now take 91.8 cents U.S. to buy one Canadian dollar.

One of the most well-known applications of the PPP method is illustrated by thene of the most well-known applications of the PPP method is illustrated by the Big Macig Mac

Indexndex, compiled and published bycompiled and published by The he Economist conomist. This light-hearted index attempts to This light-hearted index attempts to

measure whether a currency is undervalued or overvalued based on the price of Big Macs ineasure whether a currency is undervalued or overvalued based on the price of Big Macs in

various countries. Since Big Macs are nearly universal in all the countries they are sold, aarious countries. Since Big Macs are nearly universal in all the countries they are sold, a

comparison of their prices serves as the basis for the index. (To learn more, check outomparison of their prices serves as the basis for the index. (To learn more, check out The Big he Big

Mac Index: Food For Thought ac Index: Food For Thought.))

Relative Economic Strength Approachelative Economic Strength Approach

As the name may suggest, the relative economic strength approach looks at the strength of s the name may suggest, the relative economic strength approach looks at the strength of

economic growth in different countries in order to forecast the direction of exchange rates.conomic growth in different countries in order to forecast the direction of exchange rates.

The rationale behind this approach is based on the idea that a strong economic environmenthe rationale behind this approach is based on the idea that a strong economic environment

and potentially high growth is more likely to attract investments from foreign investors. And,nd potentially high growth is more likely to attract investments from foreign investors. And,

in order to purchase investments in the desired country, an investor would have to purchasen order to purchase investments in the desired country, an investor would have to purchase

the country's currency - creating increased demand that should cause the currency tohe country's currency - creating increased demand that should cause the currency to

appreciate.ppreciate.

This approach doesn't just look at the relativehis approach doesn't just look at the relative

economic strength between countries. It takes aconomic strength between countries. It takes a

more general view and looks at all investmentore general view and looks at all investment

flows. For instance, another factor that can drawlows. For instance, another factor that can draw

investors to a certain country isnvestors to a certain country is interest ratesnterest rates.

High interest rates will attract investors lookingigh interest rates will attract investors looking

for the highest yield on their investments, causingor the highest yield on their investments, causing

demand for the currency to increase, which againemand for the currency to increase, which again

would result in an appreciation of the currency.ould result in an appreciation of the currency.

Conversely, low interest rates can also sometimesonversely, low interest rates can also sometimes

induce investors to avoid investing in a particular country or even borrow that country'snduce investors to avoid investing in a particular country or even borrow that country's

currency at low interest rates to fund other investments. Many investors did this with theurrency at low interest rates to fund other investments. Many investors did this with the

Japanese yen when the interest rates in Japan were at extreme lows. This strategy isapanese yen when the interest rates in Japan were at extreme lows. This strategy is

commonly known as theommonly known as the carry-tradearry-trade. (Learn more about the carry trade in(Learn more about the carry trade in Profiting From rofiting From

Carry Trade Candidates arry Trade Candidates.))

Unlike the PPP approach, the relative economic strength approach doesn't forecast what thenlike the PPP approach, the relative economic strength approach doesn't forecast what the

exchange rate should be. Rather, this approach gives the investor a general sense of whether axchange rate should be. Rather, this approach gives the investor a general sense of whether a

currency is going to appreciate or depreciate and an overall feel for the strength of theurrency is going to appreciate or depreciate and an overall feel for the strength of the

movement. This approach is typically used in combination with other forecasting methods toovement. This approach is typically used in combination with other forecasting methods to

develop a more complete forecast.evelop a more complete forecast.

Econometric Modelsconometric Models

Another common method used to forecast exchange rates involves gathering factors that younother common method used to forecast exchange rates involves gathering factors that you

believe affect the movement of a certain currency and creating a model that relates theseelieve affect the movement of a certain currency and creating a model that relates these

factors to the exchange rate. The factors used inactors to the exchange rate. The factors used in econometricconometric models are normally based onmodels are normally based on

economic theory, but any variable can be added if it is believed to significantly influence theconomic theory, but any variable can be added if it is believed to significantly influence the

exchange rate.xchange rate.

As an example, suppose that a forecaster for a Canadian company has been tasked withs an example, suppose that a forecaster for a Canadian company has been tasked with

forecasting the USD/CAD exchange rate over the next year. He believes an econometricorecasting the USD/CAD exchange rate over the next year. He believes an econometric

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model would be a good method to use and has researched factors he thinks affect theodel would be a good method to use and has researched factors he thinks affect the

exchange rate. From his research and analysis, he concludes the factors that are mostxchange rate. From his research and analysis, he concludes the factors that are most

influential are: thenfluential are: the interest rate differentialnterest rate differential between the U.S. and Canada (INT), the differencebetween the U.S. and Canada (INT), the difference

in GDP growth rates (GDP), and income growth rate (IGR) differences between the twon GDP growth rates (GDP), and income growth rate (IGR) differences between the two

countries. The econometric model he comes up with is shown as:ountries. The econometric model he comes up with is shown as:

USD/CAD (1-year) = z + a(INT) + b(GDP) + c(IGR)SD/CAD (1-year) = z + a(INT) + b(GDP) + c(IGR)

We won't go into the details of how the model is constructed, but after the model is made, thee won't go into the details of how the model is constructed, but after the model is made, the

variables INT, GDP and IGR can be plugged into the model to generate a forecast. Theariables INT, GDP and IGR can be plugged into the model to generate a forecast. The

coefficients a, b and c will determine how much a certain factor affects the exchange rate andoefficients a, b and c will determine how much a certain factor affects the exchange rate and

direction of the effect (whether it is positive or negative). You can see that this method isirection of the effect (whether it is positive or negative). You can see that this method is

probably the most complex and time-consuming approach of all the ones discussed so far.robably the most complex and time-consuming approach of all the ones discussed so far.

However, once the model is built, new data can be easily acquired and plugged into the modelowever, once the model is built, new data can be easily acquired and plugged into the model

to generate quick forecasts.o generate quick forecasts.

Time Series Modelime Series Model

The last approach we'll introduce you to is thehe last approach we'll introduce you to is the time seriesime series model. This method is purelymodel. This method is purely

technical in nature and is not based on any economic theory. One of the more popular timeechnical in nature and is not based on any economic theory. One of the more popular time

series approaches is called the autoregressive moving average (ARMA) process. The rationaleeries approaches is called the autoregressive moving average (ARMA) process. The rationale

for using this method is based on the idea that past behavior and price patterns can be used toor using this method is based on the idea that past behavior and price patterns can be used to

predict future price behavior and patterns. The data you need to use this approach is simply aredict future price behavior and patterns. The data you need to use this approach is simply a

time series of data that can then be entered into a computer program to estimate theime series of data that can then be entered into a computer program to estimate the

parameters and essentially create a model for you.arameters and essentially create a model for you.

Bottom Lineottom Line

Forecasting exchange rates is a very difficult task, and it is for this reason that manyorecasting exchange rates is a very difficult task, and it is for this reason that many

companies and investors simply hedge their currency risk. However, there are others who seeompanies and investors simply hedge their currency risk. However, there are others who see

value in forecasting exchange rates and want to understand the factors that affect theiralue in forecasting exchange rates and want to understand the factors that affect their

movements. For people who want to learn to forecast exchange rates, these four approachesovements. For people who want to learn to forecast exchange rates, these four approaches

are a good place to start. (Learn more about currencies and forex trading inre a good place to start. (Learn more about currencies and forex trading in Top 10 Forex op 1 Forex

Trading Rules rading Rules.))

FOREX FUNDAMENTALSOREX FUNDAMENTALS

3 Ways To Forecast Currency Changes Ways To Forecast Currency Changes

Forecasting exchange rates can help minimize risks and maximize returns.orecasting exchange rates can help minimize risks and maximize returns.Here are three popular methods for forecasting exchange rates.ere are three popular methods for forecasting exchange rates.

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Inflation occurs when an economy grows due to increased spending.nflation occurs when an economy grows due to increased spending.

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