Forecasting Exchange Rates

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Forecasting Exchange Rates
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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

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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.

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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

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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.

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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

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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

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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
  markets 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.

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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

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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

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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.

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Technical Analysis

• Go to FXStreet.com to review some technical
  patterns.
• http//www.fxstreet.com/rates-charts/forex-charts/