Question

A) How to use PPP for fundamental analysis?

B)Why can current spot rate be used to forecast the spot rate in the future?

Answer 1

Part (A)

Fundamental analysis aims to establish or depict relationship between the fundamental economic variables and exchange rates. Fundamental analysis is required to forecast exchange rates based on variables such as inflation, interest rate, income level, growth in income level etc.

PPP is one of the simplest way to generate this forecast. Purchasing power parity in theory establishes the equilibrium between exchange rate, interest rate and inflation. Let me explain this by using an example:

Assume that current $ to Euro exchange rate is $ 1.12 per Euro. Assume that inflation rate in US is expected to be around 2% in USA and 4% in Europe. Hence, predict the exchange rate for $ to Euro in two years' time.

S₀ ($ / Euro) = 1.12

Inflation rate, I_US = 2%

Inflation rate, I_Euro = 4%

Hence, expected exchange rate ($ / Euro) after "n" years = S₀ x (1 + I_US)ⁿ / (1 + I_Euro)ⁿ = 1.12 x (1 + 2%)² / (1 + 4%)² = $ 1.08 per Euro.

Thus, you have just seen an application of PPP to forecast the future (expected spot price). Thus PPP can be used for fundamental analysis and forecast the exchange rate. The benefits include:

1. It's simplistic
2. Doesn't involve painstakingly long analysis or regression
3. Works upon inflation and interest rate forecasts that are easily available

Part (B)

It's important for us to understand that any variable that changes, say on a daily basis, will assume a value tomorrow which will be a higher than or a lower than or same value as today. If the variable is completely random, the best forecast of the price tomorrow is the value of the variable today.

Similarly, spot rate today is the best forecast for tomorrow's spot rate is today's spot rate. Hence, the current spot rate can be used to forecast the spot rate in future because:

• The current spot rate is an unbiased reflection of the spot exchange rate likely to prevail on any future maturity date.
• The current spot exchange rate is also an efficient forecast of the future likely exchange rate.
• The current spot rate is expected to reflect the market’s expectation of the future spot rate.

Hence, spot rate is the best forecast for future's exchange rate.