Question

Estimate the value of the Canadian dollar with respect to the US$ in one years time .How did you estimate future exchange rates. Why do you think it would work?  

Answer 1

The U.S. Dollar-Canadian Dollar exchange rate is forecast at 1.3333 by the end of September 2020, 1.3514 by year-end, 1.333 by the end of March 2021 and 1.3158 by the end of June 2021. The current spot price of USD/CAD is at 1.3146.

3 Common Ways to Forecast Currency Exchange Rates

Using a currency exchange rate forecast can help brokers and businesses make informed decisions to help minimize risks and maximize returns. Many methods of forecasting currency exchange rates exist. Here are the most popular methods: purchasing power parity, relative economic strength, and econometric models.

Purchasing Power Parity

The purchasing power parity (PPP) is perhaps the most popular method due to its indoctrination in most economic textbooks. The PPP forecasting approach is based on the theoretical law of one price, which states that identical goods in different countries should have identical prices.

According to purchasing power parity, a pencil in Canada should be the same price as a pencil in the United States 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 inexpensive pencils in one country and sell them in another for a profit.

The PPP approach forecasts that the exchange rate will change to offset price changes due to inflation based on this underlying principle.

Relative Economic Strength

As 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. The rationale behind this approach is based on the idea that a strong economic environment and potentially high growth are more likely to attract investments from foreign investors. And, in 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 to appreciate.

This approach doesn't just look at the relative economic strength between countries. It takes a more general view and looks at all investment flows. For instance, another factor that can draw investors to a certain country is interest rates. High interest rates will attract investors looking for the highest yield on their investments, causing demand for the currency to increase, which again would result in an appreciation of the currency.

Econometric Models of Forecasting Exchange Rates

Another common method used to forecast exchange rates involves gathering factors that might affect currency movements and creating a model that relates these variables to the exchange rate. The factors used in econometric models are typically based on economic theory, but any variable can be added if it is believed to significantly influence the exchange rate.

As an example, suppose that a forecaster for a Canadian company has been tasked with forecasting the USD/CAD exchange rate over the next year. They believe an econometric model would be a good method to use and has researched factors they think affect the exchange rate. From their research and analysis, they conclude the factors that are most influential are: the interest rate differential between the U.S. and Canada (INT), the difference in GDP growth rates (GDP), and income growth rate (IGR) differences between the two countries.

Overview

Exchange rates always apply to the cost of one currency relative to another. The order in which the pair are listed (USD/CAD versus CAD/USD) matters. Remember the first currency is always equal to one unit and the second currency is how much of that second currency it takes to buy one unit of the first currency. From there you can calculate your conversion requirements. Banks will markup the price of currencies to compensate themselves for the service. Shopping around may save you some money as some companies will have a smaller markup, relative to the market exchange rate, than others.