Question

What are the various ways that are employed to forecast exchange rates and comment on their strengths and weaknesses? To what extent should the international financial manager take account of these forecasts in carrying out their function? (600 WORDS)

Answer 1

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.

KEY TAKEAWAYS
Currency exchange rate forecasts help brokers and businesses make better decisions.
Purchasing power parity looks at the prices of goods in different countries and is one of the more widely used methods for forecasting exchange rates due to its indoctrination in textbooks.
The relative economic strength approach compares levels of economic growth across countries to forecast exchange rates.
Lastly, econometric models can consider a wide range of variables when attempting to understand trends in the currency markets.
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.

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.

Conversely, low interest rates can also sometimes induce 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 the Japanese yen when the interest rates in Japan were at extreme lows.2 This strategy is commonly known as the carry trade.

The relative economic strength method doesn't forecast what the exchange rate should be, unlike the PPP approach. 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 the movement. It is typically used in combination with other forecasting methods to produce a complete result.

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.