Forecasting Exchange Rates Two Approaches to Forecasting Fundamental

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/