Methods of predicting exchange rates
In order to predict the future dynamics of a currency pair a huge number of techniques have been developed. Nevertheless, quantity has not turned into quality and it is not the easiest task to make a rather effective forecast. Let's take a look at the four most common methods of predicting currency pair rates.
Purchasing power parity theory (PPP)
Purchasing power parity (PPP) is probably the most popular method. It is mentioned most often in economics textbooks. PPP theory is based on the "law of one price," which states that the cost of identical goods in different countries must be the same.
For example, the price of a cabinet in Canada should be similar to the price of the same cabinet in the United States, taking into account the exchange rate and excluding transportation and exchange costs. That is, there should be no reason for speculation to buy cheaply in one country and sell more expensively in another.
According to PPP theory, changes in the exchange rate should compensate for inflationary price increase. For example, this year prices in the United States should rise by 4%, in Canada by 2% over the same period. Thus, the inflation differential is: 4% - 2% = 2%.
Accordingly, prices in the U.S. will rise faster than in Canada. According to PPP theory, the U.S. dollar must lose about 2% in value in order for the price of the same product in the two countries to remain approximately the same. For example, if the exchange rate was 1 CAD=0.9 USD, the PPP theory calculates the projected rate as follows:
(1 + 0.02) x (0.90 USD per 1 CAD) = 0.918 USD per 1 CAD
That is, to comply with the PPP, the Canadian dollar must rise to 91.8 U.S. cents.
The most common example of using the PPP principle is the Big Mac Index, which is based on comparing its price in different countries, and which shows the level of undervaluation and overvaluation of the currency.
The principle of relative economic stability
The methodology of this approach is described in the name itself. The growth rates of different economies are taken as a basis, which makes it possible to predict the dynamics of the exchange rate. It is logical to assume that stable economic growth and a healthy business climate will attract more foreign investment. Investment requires the purchase of national currency, which consequently leads to an increase in demand for the national currency and its subsequent strengthening.
This method is not only suitable for comparing the economies of the two countries. It can be used to form an opinion on the availability and intensity of investment flows. For example, investors are attracted by higher interest rates, allowing them to get the maximum return on their investments. Accordingly, the demand for the national currency grows again and its strengthening takes place.
Low interest rates can reduce the flow of foreign investment and stimulate domestic lending. This is the case in Japan, where interest rates have been cut to record lows. There is a trade strategy "CARRY TRADEbased on interest rate differentials.
The difference between the relative economic stability principle and the PPP theory is that it cannot be used to forecast the size of the currency. It gives the investor only a general idea about the prospects of strengthening or weakening of the currency and the strength of the momentum. To get a more complete picture, the principle of relative economic stability is combined with other forecasting methods.
Building an econometric model
A very popular method for predicting exchange rates is creating a model that describes the relationship between the exchange rate and the factors that, according to an investor or trader, influence its movement. As a rule, econometric models are based on the values from economic theory, however any other variables influencing the exchange rate can be used in the calculations.
Let's take, for example, making a forecast for the next year for the pair USD/CAD. As key factors for the pair dynamics we choose: the difference (differential) of US and Canadian interest rates (INT), difference in GDP growth rate (GDP) and the difference between the growth rates of personal income in the United States and Canada (IGR). The econometric model in this case will have the following form:
USD/CAD (1 year) = z + a(INT) + b(GDP) + c(IGR)
The coefficients a, b and c can be both negative and positive, and show how strong the influence of the corresponding factor is. It is worth noting that the method is quite complex, but if you have a ready-made model, you can simply substitute new data to get a prediction.
Time series analysis
The method of time series analysis is purely technical and does not take into account economic theory. The most popular model in time series analysis is the autoregressive moving average (ARMA) model. The method is based on the principle of forecasting the price patterns of a currency pair on the basis of the past dynamics. The calculation is carried out by a special computer program based on the entered parameters of a time series, the result of which is the creation of an individual price model for a particular currency pair.
Undoubtedly, predicting exchange rates is an extremely difficult task. Many investors simply prefer to insure currency risks. Other investors are aware of the importance of forecasting exchange rates and seek to understand the factors influencing them. The above methods can be of great help to such market participants.