Forecasting Exchange Rates
Two Approaches to Forecasting
• Fundamental Analysis
– Examines economic relationships and financial
data to arrive at a forecast.
• Short term horizons: Asset Choice Model
• Long term horizons: Parity Models
• Technical Analysis
– Relies on historical price patterns to arrive at a
forecast.
• Generally very short term horizons
Fundamental Analysis: Short Trerm
• Asset Choice:
– Examines why one currency might be preferred
over others. Variables include:
•
•
•
•
Relative interest rates (current and anticipated)
Political/country risk
Safe haven effects
Carry trade strategies and carry trade unwinds
– Essentially, trying to identify why the demand for
a currency will change.
Fundamental Analysis: Long Term
• Parity Models
– Through these models one attempts to calculate
an “equilibrium” exchange rate in the future.
– Analysis built on “long standing” economic
theories of exchange rate determination.
• Purchasing Power Parity Model
• International Fisher Effect
Purchasing Power Parity
• One of the oldest exchange rate models.
• Assumes that exchange rates will change to offset
relative prices levels between countries.
– Countries with relatively high rates of inflation will
show currency depreciation
– Countries with relatively low rates of inflation will
experience currency appreciation
• In equilibrium, the amount of depreciation (or
appreciation) will be equal to the inflation
differential.
Purchasing Power Parity Example
• Assume:
– Spot GBP/USD: $1.80
– Forecasted UK rate of inflation (annualized) for the next 12
months: 2.5%
– Forecasted US rate of inflation (annualized) for the next 12
months: 1.0%
• PPP Spot GBP/USD Forecast
– 1 year change in GBP: $1.80 x .015 = 0.027.
– 1 year spot GBP: $1.80 - .027 = $1.773
– 6 month GBP: $1.80 – (0.027/2) = $1.80 – 0.0135 = $1.7865
Purchasing Power Parity Example
• Assume:
– Spot USD/CAD: 1.20
– Forecasted CAD rate of inflation (annualized) for the
next 12 months: .5%
– Forecasted US rate of inflation (annualized) for the
next 12 months: 2.5%
• PPP Spot USD/CAD Forecast
– 1 year change in CAD: 1.20 x .020 = 0.024.
– 1 year spot CAD: 1.20 - 0.024 = 1.176
– 6 month CAD: 1.20 – (.024/2) = 1.20 - .012 = 1.188
International Fisher Effect
• Assume that exchange rates will change in direct
proportion to relative differences in long term interest
rates.
– Assumes that long term interest rates capture the market’s
expectation for inflation.
– Countries with relatively high rates of long term interest
rates (i.e., high inflation) will show currency depreciation.
– Countries with relatively low rates of long term interest
rates (i.e., low inflation) will show currency appreciation.
• In equilibrium, the amount of depreciation (or
appreciation) will be equal to the long term interest
rate differential.
International Fisher Effect Example
• Assume:
– Spot EUR/USD = $1.50
– Current 1 year German Government Bond rate =
2.15%
– Current 1 year U.S. Government Bond rate = 4.5%
• IFE Spot EUR/USD Forecast
– 1 year change in EUR = $1.50 x 0.0235 = 0.03525
– 1 year spot EUR = $1.50 + .03525 = $1.53525
International Fisher Effect Example
• Assume:
– Spot USD/JPY = 98.00
– Current 1 year Japanese Government Bond rate =
0.5%
– Current 1 year U.S. Government Bond rate = 4.5%
• IFE Spot USD/JPY Forecast
– 1 year change in JPY = 98.00 x 0.04 = 3.92
– 1 year spot JPY = 98.00 - 3.92 = 94.08
Technical Analysis
• Uses charts and price patterns to forecast
future moves in spot exchange rates.
– Looks for price patterns that have historically
signed a future move.
– Assume historical relationship will result in similar
moves in the future.
• Not interested in “explaining” the source of
the expected future move.
– Not interested in financial information or news.
Technical Analysis
• Go to FXStreet.com to review some technical
patterns.
• http://www.fxstreet.com/rates-charts/forexcharts/