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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, forex.forecast.aspx. Many methods of forecasting currency exchange rates exist.
Here, we'll look at a few of the forex.forecast.aspx popular methods: purchasing power parity, relative economic strength, and econometric models, forex.forecast.aspx. The purchasing power parity PPP is perhaps the most popular method due to its indoctrination in most economic textbooks.
The PPP forex.forecast.aspx approach is based on the theoretical law of one price forex.forecast.aspx, which states that identical goods in different countries should have identical prices. According forex.forecast.aspx purchasing power parity, a pencil in Canada should be the forex.forecast.aspx price forex.forecast.aspx a pencil in the United States after taking into account the exchange rate and excluding transaction and shipping costs, forex.forecast.aspx.
In other words, forex.forecast.aspx, 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 forex.forecast.aspx will change to offset price changes forex.forecast.aspx to inflation based on this underlying principle, forex.forecast.aspx.
To use the above example, forex.forecast.aspx, suppose that the prices of pencils in the U. The inflation differential between the two countries is:. This means that prices of pencils in the U, forex.forecast.aspx. are expected to rise faster relative to prices in Canada.
In this situation, the purchasing power parity approach would forecast that the U. So, if the forex.forecast.aspx exchange rate was 90 cents U. per one Canadian dollar, then the PPP would forecast an exchange rate of:. Meaning it would now take 92 cents U. to buy one Canadian dollar, forex.forecast.aspx. One of the most well-known applications of the PPP method is illustrated by the Big Mac Indexcompiled and published by The Economist. This lighthearted index attempts to measure whether a currency is undervalued or overvalued based on the price of Big Macs in various countries, forex.forecast.aspx.
Since Big Macs are nearly universal in all the countries they are sold, forex.forecast.aspx, a comparison of their prices serves as the basis for the index. 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 forex.forecast.aspx 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, forex.forecast.aspx. This approach doesn't just look at the forex.forecast.aspx economic strength between forex.forecast.aspx. It takes a more general view and looks at all investment flows, forex.forecast.aspx. For instance, forex.forecast.aspx, another factor that can draw investors to a forex.forecast.aspx 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, forex.forecast.aspx, 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. This strategy is commonly known as the carry trade. The relative economic strength method doesn't forecast what the exchange rate should be, forex.forecast.aspx, 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 forex.forecast.aspx forecasting methods to produce a complete result. 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, forex.forecast.aspx, but any variable can be added if it is believed to significantly influence the exchange rate, forex.forecast.aspx. They believe an econometric model would be a good method to use and has researched factors they think affect the exchange rate, forex.forecast.aspx. From their research and analysis, they conclude the factors that are most influential are: the interest rate differential between the U.
and Canada INTthe difference in GDP growth rates GDPand income growth rate IGR differences between the two countries, forex.forecast.aspx. Forex.forecast.aspx econometric forex.forecast.aspx they come up with is shown as:, forex.forecast.aspx. After the model is created, forex.forecast.aspx, the variables INT, GDP and IGR can be plugged in to generate a forecast, forex.forecast.aspx.
The coefficients a, b, forex.forecast.aspx, and c will determine how much a forex.forecast.aspx factor affects the exchange rate and direction of the effect whether it is positive or negative, forex.forecast.aspx.
This method is probably the most complex and time-consuming approach, but once the model is built, new data can be easily acquired and plugged in to generate quick forecasts. Forecasting exchange rates is a very difficult task, and it is for this reason that many companies and investors simply hedge their currency risk, forex.forecast.aspx.
However, those who see value in forecasting exchange rates and want to understand the factors that affect their movements can use these approaches as a good place to begin their research. The Economist, forex.forecast.aspx. Financial Analysis, forex.forecast.aspx. Your Money, forex.forecast.aspx. Personal Finance, forex.forecast.aspx. Your Practice. Popular Courses, forex.forecast.aspx. Key Takeaways Currency exchange rate forecasts help brokers and businesses make better decisions, forex.forecast.aspx.
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 forex.forecast.aspx in textbooks. The relative economic strength approach compares levels of economic growth across countries forex.forecast.aspx forecast exchange rates. Lastly, econometric models can consider a forex.forecast.aspx range of variables when attempting to understand trends in forex.forecast.aspx currency markets.
Article Sources. Investopedia requires writers to use primary sources to support their work, forex.forecast.aspx. These include forex.forecast.aspx papers, government data, forex.forecast.aspx, original reporting, forex.forecast.aspx, and interviews with industry experts.
We also reference original research from other reputable publishers where appropriate, forex.forecast.aspx. You can learn more about the standards we follow in forex.forecast.aspx accurate, unbiased content in our editorial policy, forex.forecast.aspx. Compare Accounts.
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Macroeconomics The Economy of Canada: An Explainer. Financial Analysis Business Forecasting, forex.forecast.aspx. Partner Forex.forecast.aspx. Related Terms Gross Domestic Product GDP Gross domestic product GDP is the monetary value of all finished goods and services made within a country during a specific period, forex.forecast.aspx.
What Is the Big Mac PPP? The Big Mac PPP is a survey done by The Economist that examines the purchasing power of various currencies based on the relative price of a Big Mac. dollar vs Canadian dollar cross rate. Interest Rate Parity IRP Interest rate parity IRP is the fundamental equation that governs the forex.forecast.aspx between interest rates and foreign exchange rates.
Oman Rial Forex.forecast.aspx Definition OMR is the currency symbol for the Omani rial, the currency of the Sultanate of Oman, which is pegged to the U, forex.forecast.aspx. Currency Symbol Definition and Examples A currency symbol is a graphical representation substituted for the name of a currency, which is usually unique to a specific country or region.
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