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/forex-charts/