Question

List and describe the various methods of forecasting exchange rates

Answer 1

3 Common Ways to Forecast Currency Exchange Rates

1.Purchasing Power Parity

2.Relative Economic Strength

3.Econometric Models of Forecasting Exchange Rates

1.Purchasing Power Parity

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.

EXAMPLE:

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. To use the above example, suppose that the prices of pencils 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 differential between the two countries is: 4%-2%= 2%

2.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.

3.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.

EXAMPLE:

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 to 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. The econometric model they come up with is shown as:

USD/Cad(1 - Year)=z+a(INT)+b(GDP)+c(IGR)

where:z=Constant baseline exchange rate

a,b and c=Coefficients representing relativeweight of each factor

INT=Difference in interest rates betweenU.S. and Canada

GDP=Difference in GDP growth rates

IGR=Difference in income growth rates​