Exchange rate forecasts are drawn up through the computation of a currency’s value vis-à-vis other currencies over a period of time. While there are various theories that can be used to predict exchange rates, all of them have limitations. No model has been able to establish a monopoly in the forecasting process.
Exchange Rate Forecast: Approaches Employed
The two most commonly used methods for forecasting exchange rates are:
- Fundamental Approach: It forecasts exchange rates after considering the factors that give rise to long term cycles. Elementary data related to a country, such as GDP, inflation rates, productivity indices, balance of trade and unemployment rate, are taken into account. This approach is based on the premise that the ‘true worth’ of a currency will eventually be realized. Hence, this approach is suitable for long term investments.
- Technical Approach: This approach is based on the premise that it is investor sentiment that determines changes in the exchange rate and makes predictions by charting out patterns. Other tools used in this approach are positioning surveys, moving-average trend-following trading rules and FX dealer customer-flow data. Fund managers use these patterns to take informed decisions for short term investments.
Exchange Rate Forecast: Models
Some important exchange rate forecast models are:
- Purchasing Power Parity (PPP) Model: This method involves studying exchange rate movements based on the price level changes in each country.
- Uncovered Interest Rate Parity (UIP) Model: This model forecasts exchange rate movements in accordance with returns from investment in the two curencies. The UIP creates an arbitrage mechanism that sets an exchange rate which equalizes returns from domestic and foreign assets.
- Random Walk Model: This approach assumes that all available information on exchange rate movements in the future is reflected in the current exchange rate. Also, any future event leading to a change in exchange rates is purely random from today’s perspective. Thus, the best possible forecast of a currency’s value is its value today. This is the simplest approach for exchange rate forecasting.
A 1983 study by Meese and Rogoff depicted the superiority of the Random-Walk Model. However, exchange rate forecast models such as the PPP and UIP have also given successful predictions over longer timeframes. Exchange rate forecasts works best if there is a combined effort using these models.