Models of fundamental analysis and prediction of exchange rates in FOREX

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A newcomer to trading who reads analytical tapes, fundamental analysis can seem like a set of highly subjective conclusions and assumptions of analysts. It is not uncommon for experts to hold diametrically opposed views on the same events, juggling information as they see fit to justify their own position.

Meanwhile, objective analysis can be defined as analysis based on clearly defined and verifiable rules. Even if these rules are based on fundamental analysis, they can be objective and thus verifiable. For example, "buy when interest rates rise, sell when interest rates fall" is a perfectly objective rule, whereas the technical analysis idea of "buy on uptrend and sell on the downtrend" is subjective in terms of defining these trends. And this is where the trader can help models of fundamental analysis and prediction of exchange rates on FOREX.

Articles of the "Fundamental Analysis" Master Class

Models for predicting floating exchange rates

If you read a textbook on international finance, you will learn that fundamental exchange rate analysis is a much more formalized process than it might seem at first glance. Economists distinguish two groups of methods for predicting floating exchange rates: market-based and model-based. As is clear from the name, market-based methods mean that the market itself will help to forecast the exchange rate. For example, according to the unbiased forward rate hypothesis, the forward rate is a forecast of the spot (i.e. current) rate in a future period. As for the model-based approach, it includes both technical and fundamental analysis.

Fundamental forecasts are based on changes in economic factors affecting exchange rates. There are many such factors. As an example, below is the relationship between the U.S. dollar exchange rate and some of them:

Models of fundamental analysis and prediction of exchange rates in FOREX — Figure 1. Table of correlation between the dollar exchange rate and economic factors.

Inflationary component

Conditions of parity in international financial markets (the establishment of equilibrium relations of product prices, interest rates, spot and forward exchange rates) allow for the quantitative calculation of these relationships. Thus, purchasing power parity - the concept that currency exchange rates are determined in the long run by the amount of goods and services that each can buy - allows for a forecast of future exchange rates based on an estimate of inflation in two countries. The currency of the country whose inflation rate is expected to be higher is expected to become cheaper relative to the currency of the country whose prices are expected to rise more slowly.

In the above formula, it all depends on what the expected inflation in the next period. Usually the PPP provides an unbiased estimate of exchange rate changes over the long run, but even by correctly forecasting inflation, it is possible to obtain a forecast value that will be very far from the actual one. Thus, inflation expectations are an important factor, but there are other factors that should be taken into account when making a more complete fundamental model.

Models of fundamental analysis of the currency market

Typically, fundamental models are regression models in which the dependent variable is the future exchange rate, various economic factors act as independent variables.

A fundamental model can include one or more factors. For example, we can make the following model:

This model assumes that the change in the exchange rate in the next period is determined by the level of inflation and interest rates for the current period.

To determine the coefficients b0, b1 and b2 use historical data, then substitute in the equation the values of inflation and interest differential for the current period to get a forecast of exchange rate changes for the next period.

Of course, this is a simplified version: this type of model usually requires more than two independent variables. Currency traders of banks make up multi-factor fundamental models. In addition, this example considers a model that uses inflation levels and interest rates with a time lag. Other models may use predicted values of independent variables in the next period, but then it will be as good as the prediction of those variables turns out to be.

Application of models of fundamental analysis and prediction of exchange rates in Forex

Model fundamental analysis is oriented to a relatively long-term period of time - from a month and more. Meanwhile, news trading, so beloved by some and hated by others, is a short-term affair. Everything here is based on market expectations, formed by consensus forecasts, published at such websites as Bloomberg and Reuters. Often fundamental Forex reviews are based on market expectations for specific indicators economic calendarwhich makes such reviews more subjective.

When carrying out a complex fundamental analysis, one should try to make it as less subjective and more objective as possible. It means that before the analysis the trader should not have a ready-made forecast, under which he will then fit all the factors and expectations. On the contrary, the trader must first study all factors and data and make a judgment (the same is true for tehanalysis).

The most effective application of fundamental analysis is to determine the direction of the medium- and long-term trend. One of the most important factors in fundamental analysis is the monetary policy of central banks, because it represents a known value. So, after. central bank If a country has taken a policy easing course, there is every reason to bet on the weakening of the currency of this country in the medium and long term. In such a case, it is possible to observe a prolonged effect, which does not disperse after the publication of a positive macroeconomic indicator, but creates a trend. The optimal opportunity to trade is to find the currency of the state, whose central bank is set to tighten monetary policy or is already engaged in it, and sell the first currency against the latter.

Qualitative fundamental analysis is objective in nature. Nevertheless, there are certain difficulties associated with the construction of fundamental analysis models and the forecasting of exchange rates on Forex: in order to forecast the exchange rate, it is necessary to forecast a number of other indicators. The parameters that are used in the fundamental equations are based on historical data and can change over time. Often fundamental analysts do not build models, but estimate the general direction of the exchange rate based on the current economic statistics.