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# 3 common ways to predict exchange rates

Using an exchange rate forecast can help brokers and businesses make informed decisions to minimize risk and maximize returns. There are many methods of forecasting exchange rates. Here, we’ll take a look at some of the more popular methods: purchasing power parity, relative economic strength, and econometric models.

3 ways to predict currency changes

## Purchasing power parity

Purchasing Power Parity (PPP) is perhaps the most popular method due to its indoctrination in most economics textbooks. The PPA forecasting approach is based on the Theoretical Law of One Price, which states that identical goods in different countries must have identical prices.

Key points to remember

• Currency rate forecasts help brokers and businesses make better decisions.
• Purchasing power parity examines the prices of goods in different countries and is one of the most widely used methods of forecasting exchange rates due to its indoctrination in textbooks.
• The relative economic strength approach compares levels of economic growth between countries to forecast exchange rates.
• Finally, econometric models can take a wide range of variables into account when trying to understand trends in currency markets.

Based on purchasing power parity, a pencil in Canada should be the same price as a pencil in the United States after accounting for the exchange rate and excluding transaction and shipping fees. In other words, there should be no arbitrage opportunity for someone to buy cheap pencils in one country and sell them in another at a profit.

The PPP approach predicts that the exchange rate will change to compensate for price changes due to inflation based on this underlying principle. To use the example above, assume that the prices of pencils in the United States are expected to increase by 4% over the next year while prices in Canada are expected to increase by only 2%. The inflation differential between the two countries is:



4

%

2

%

=

2

%

begin {aligned} & 4 % – 2 % = 2 % end {aligned}

4%2%=2%

This means that the prices of pencils in the United States are expected to rise faster than prices in Canada. In this situation, the purchasing power parity approach would predict that the US dollar would have to depreciate by about 2% to keep pencil prices between the two countries relatively equal. So, if the current exchange rate were 90 cents US to the Canadian dollar, the PPP would predict an exchange rate of:



(

1

+

0.02

)

Ã—

(

US DOLLARS $0.90 per$ CA

1

)

=

US DOLLARS $0.92 per$ CA

1

begin {aligned} & (1 + 0.02) times ( text {US $} 0.90 text {by CA$} 1) = text {US $} 0.92 text {by CA$} 1 end {aligned}

(1+0.02)Ã—(US DOLLARS $0.90 per$ CA1)=US DOLLARS $0.92 per$ CA1

This means that it would now take 92 US cents to buy one Canadian dollar.

One of the most well-known applications of the PPP method is exemplified by the Big Mac Index, compiled and published by The Economist. This lightweight index attempts to measure whether a currency is undervalued or overvalued based on the price of Big Macs in various countries. Since Big Macs are almost universal in all countries where they are sold, a comparison of their prices is used as the basis for the index.

## Relative economic strength

As the name suggests, the relative economic strength approach examines the strength of economic growth in different countries in order to predict the direction of exchange rates. The rationale for this approach is based on the idea that a strong economic environment and potentially high growth are more likely to attract investment from foreign investors. And, to buy investments in the desired country, an investor would have to buy the currency of the country, thereby creating increased demand which should cause the currency to appreciate.

This approach goes beyond simply examining the relative economic strength between countries. It takes a more general view and examines all investment flows. For example, interest rates are another factor that can attract investors to a certain country. The high interest rates will attract investors looking for the highest return on their investments which will lead to an increase in demand for the currency which will cause the currency to appreciate again.

Conversely, low interest rates can also sometimes cause investors to avoid investing in a particular country or even to borrow that country’s currency at low interest rates to finance other investments. Many investors did this with the Japanese yen when interest rates in Japan were at extremely low levels. This strategy is commonly called the carry trade.

The relative economic strength method does not predict what the exchange rate should be, unlike the PPP approach. On the contrary, this approach gives the investor a general idea of â€‹â€‹the appreciation or depreciation of a currency and a general idea of â€‹â€‹the strength of the movement. It is generally used in combination with other forecasting methods to produce a complete result.

## Econometric models for forecasting exchange rates

Another commonly used method of forecasting exchange rates is to put together factors that can affect currency movements and create a model that relates those variables to the exchange rate. The factors used in econometric models are generally based on economic theory, but any variable can be added if it is believed to significantly influence the exchange rate.

For example, suppose a forecaster from a Canadian company has been assigned to forecast the USD / CAD exchange rate for the next year. They think an econometric model would be a good method to use and researched the factors that they believe affect the exchange rate. From their research and analysis, they conclude that the most influential factors are: the interest rate differential between the United States and Canada (INT), the difference in the growth rate of GDP (GDP) and differences in income growth rate (IGR) between the two. countries. The econometric model they propose is presented as follows:



USD / Cad (1 – year)

=

z

+

a

(

INT

)

+

b

(

GDP

)

+

vs

(

IGR

)

or:

z

=

Constant reference exchange rate

a

,

b

and

vs

=

Coefficients representing the relative

weight of each factor

INT

=

Interest rate difference between

United States and Canada

GDP

=

Difference in GDP growth rates

IGR

=

Difference in income growth rates

begin {aligned} & text {USD / Cad (1 – Year)} = z + a ( text {INT}) + b ( text {GDP}) + c ( text {IGR}) & textbf {where:} & z = text {Constant reference exchange rate} & a, b text {and} c = text {Coefficients representing the relative} & text {weight of each factor } & text {INT} = text {Interest rate difference between} & text {United States and Canada} & text {GDP} = text {Growth rate difference of GDP} & text {IGR} = text {Difference in income growth rates} end {aligned}

USD / Cad (1 – year)=z+a(INT)+b(GDP)+vs(IGR)or:z=Constant reference exchange ratea,b and vs=Coefficients representing the relativeweight of each factorINT=Interest rate difference betweenUnited States and CanadaGDP=Difference in GDP growth ratesIGR=Difference in income growth rates

Once the model is created, variables INT, GDP and IGR can be connected to generate a forecast. The coefficients a, b, and c will determine how much a certain factor affects the exchange rate and the direction of the effect (whether positive or negative). This method is probably the most complex and time-consuming approach, but once the model is built, new data can be easily acquired and connected to generate rapid forecasts.

Forecasting exchange rates is a very difficult task, and it is for this reason that many companies and investors are content to hedge their currency risk. However, those who see the value in forecasting exchange rates and want to understand the factors that affect their movements can use these approaches as a good starting point for their research.

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