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It is a process for forecasting exchange rates that involves gathering all relevant factors that may affect a certain currency. To forecast the exchange rate, it connects all of these aspects. The variables are usually taken from economic theory, however any variable can be added if necessary.

A foreign exchange rate forecast can assist brokers and businesses in making informed decisions that reduce risk and increase profits. There are numerous approaches for anticipating currency exchange rates. We'll look at a number of the more prevalent methodologies, including purchasing power parity, relative economic strength, and econometric models, in this section.

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3 Techniques to forecast currency changes

Purchasing Power Parity

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Because it is taught in most economic textbooks, the purchasing power parity (PPP) method is likely the most popular. The theoretical law of one price, which stipulates that comparable items in different nations should have identical pricing, underpins the PPP forecasting technique.

After taking into account the currency rate and deducting transaction and shipping fees, a pencil in Canada should cost the same as a pencil in the United States under purchasing power parity. To put it another way, someone should not be able to buy cheap pencils in one nation and profitably sell them in another.

Based on this core concept, the PPP methodology predicts that the exchange rate will move in order to counteract price changes caused by inflation. Assume that, in the next year, pencil prices in the United States will climb by 4%, whereas prices in Canada would only grow by 2%. The difference between the two countries' inflation rates is as follows:


See also: Wide range of InstaForex technical indicators.

As a result, pencil costs in the United States are likely to climb more quickly than in Canada. In this case, the buying power parity technique predicts that the US currency would have to drop by about 2% in order for pencil prices in both countries to remain relatively comparable. So, if the current exchange rate is 90 cents US per Canadian dollar, the PPP would predict:

(1+0.02)×(US $0.90 per CA $1)=US $0.92 per CA $1

This means that one Canadian dollar now costs 92 cents US.

The Big Mac Index, which is calculated and published by The Economist, is one of the most well-known uses of the PPP approach. Based on the price of Big Macs in different countries, this amusing indicator seeks to determine if a currency is undervalued or overpriced. Because Big Macs are practically ubiquitous in every country where they are offered, the index is based on a price comparison.

Comparing the Purchasing Power Parity of Different Countries

A wide range of goods and services must be evaluated in order to make meaningful price comparisons across countries. However, due to the large amount of data that must be collected and the intricacy of the comparisons that must be made, this one-to-one comparison is difficult to achieve. The International Comparison Program (ICP) was founded in 1968 by the University of Pennsylvania and the United Nations to aid in this comparison.
With this program, the ICP's PPPs are based on a global price survey that compares the costs of hundreds of different goods and services. International macroeconomists can use the program to estimate global productivity and growth.

The World Bank publishes a study every few years that compares the productivity and growth of various countries in PPP and US dollars.
Weights based on PPP measures are used by both the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD) to create predictions and policy recommendations.
Economic reforms that are advocated may have an immediate short-term influence on financial markets.

PPP is also used by certain forex traders to identify currencies that are potentially overvalued or undervalued. Investors who own foreign company stock or bonds can use the survey's PPP numbers to estimate the impact of exchange rate swings on a country's economy, and consequently on their investment.

The Relationship between Purchasing Power Parity and Gross Domestic Product

Gross domestic product (GDP) is a term used in modern macroeconomics to describe the entire monetary worth of goods and services generated inside a country. The monetary value of nominal GDP is calculated in current, absolute terms. The nominal gross domestic product is adjusted for inflation to produce real GDP.

Some accounting, on the other hand, goes even further, adjusting GDP for the PPP value. This adjustment aims to transform nominal GDP into a value that can be easily compared across nations with various currencies.

Consider a scenario in which a shirt costs $10 in the United States and 8.00 in Germany to better understand how GDP and purchase power parity function. We must first convert the 8.00 into US dollars to make an apples-to-apples comparison. The PPP would be 15/10, or 1.5, if the exchange rate was such that a shirt in Germany costs $15.00.
To put it another way, for every $1.00 spent on a shirt in the United States, it costs $1.50 to buy the identical garment in Germany using the euro.

The Relative Economic Strength

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The relative economic strength approach, as the name implies, considers the strength of economic growth in different countries in order to estimate exchange rate direction. The logic behind this strategy is that a robust economic environment with potential for significant growth is more likely to attract foreign investment.

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Furthermore, in order to purchase investments in the target country, an investor must first purchase the country's currency, resulting in higher demand for the currency, which should drive it to appreciate.

This strategy considers more than just a country's relative economic strength. It looks at all investment flows in a broader sense. Interest rates, for example, are another element that can attract investors to a country. High interest rates will attract investors looking for the maximum return on their investments, prompting demand for the currency to rise, resulting in a currency appreciation.

Low interest rates, on the other hand, may tempt investors to avoid investing in a particular country or to borrow that country's currency at low rates to fund other investments. When Japan's interest rates were at historic lows, many investors did this with the yen. The carry trade is a typical name for this approach.

Unlike the PPP technique, the relative economic strength method does not forecast what the exchange rate should be. Rather, this method provides an investor with an overall idea of whether a currency will appreciate or depreciate, as well as the strength of the movement. It is frequently used in conjunction with other forecasting methodologies to produce a full result.

The relative economic strength model considers the strength of economic growth in various countries to determine the direction of exchange rates. This method is based on the assumption that growth in the economy will attract more foreign investment. To purchase these investments in a specific country, the investor will acquire the currency of that country, hence raising demand and price (appreciation).

A country's interest rates are another aspect that attracts investment. High interest rates will entice more investors, resulting in an increase in demand for that currency, allowing it to gain.

Low interest rates, on the other hand, will discourage investors from making investments in a certain country. Investors may even borrow the low-cost currency of that country to fund other projects. When interest rates on the Japanese yen were extraordinarily low, this was the case. Carry-trade approach is what it's known as.

In comparison to the PPP technique, the relative economic strength methodology does not accurately predict future exchange rates. It simply indicates whether a currency will appreciate or fall in value.

Exchange Rate Forecasting Econometric Models

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Another typical strategy for forecasting exchange rates is to collect information that may influence currency movements and build a model that connects these variables to the exchange rate. The elements in econometric models are usually based on economic theory, but any variable can be included if it is thought to have a significant impact on the exchange rate.

Consider the case of a forecaster for a Canadian corporation tasked with predicting the USD/CAD exchange rate for the coming year. They believe an econometric model would be a suitable tool to utilize, and they've looked at the elements that influence the exchange rate. The interest rate differential between the US and Canada (INT), the difference in GDP growth rates (GDP), and the income growth rate (IGR) variances between the two countries are based to their research and analysis, the most important factors. The econometric model they devise is as follows:

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

in which:
  • z=Baseline exchange rate that remains constant
  • a,b, and c=Coefficients reflecting each factor's relative weight
  • INT=Interest rate differential between two countries.
  • Canada and the United States of America
  • GDP is the difference between the growth rates of the economy.
  • See also: Wide range of InstaForex technical indicators.

  • IGR=Income Growth Rate Difference

The variables INT, GDP, and IGR can be inserted into the model after it has been established to generate a forecast. The coefficients a, b, and c will indicate how much and in which direction a specific factor influences the exchange rate (whether it is positive or negative). This is the most complicated and time-consuming way, but once the model is in place, fresh data can be readily gathered and fed in to provide speedy forecasts.

Because forecasting exchange rates is difficult, many businesses and investors prefer to hedge their currency risk. Those who see the benefit in projecting exchange rates and wish to learn more about the elements that influence their movements might start their studies with these methods.

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Bottom Line
  • Brokers and corporations can benefit from currency exchange rate projections.
  • Because of its inclusion in textbooks, purchasing power parity examines the costs of commodities in various nations and is one of the more extensively used approaches for projecting exchange rates.
  • To forecast exchange rates, the relative economic strength technique compares economic growth levels across countries.
  • Finally, when seeking to comprehend currency market movements, econometric models can take into account a wide range of variables.