Many entities have an interest in being able to forecast the direction of exchange rates. Whether you are a business or a trader, having an exchange rate forecast to guide your decision making can be very important to minimize risks and maximize returns.
TUTORIAL: Economic Indicators To Know

There are numerous methods of forecasting exchange rates, likely because none of them have been shown to be superior to any other. This speaks to the difficulty of generating a quality forecast. However, this article will introduce you to four of the most popular methods for forecasting exchange rates.

Purchasing Power Parity (PPP)
The purchasing power parity (PPP) is perhaps the most popular method due to its indoctrination in most economic textbooks. The PPP forecasting approach is based off of the theoretical Law of One Price, which states that identical goods in different countries should have identical prices.

For example, this law argues that a pencil in Canada should be the same price as a pencil in the U.S. after taking into account the exchange rate and excluding transaction and shipping costs. In other words, there should be no arbitrage opportunity for someone to buy pencils cheap in one country and sell them in another for a profit.

Based on this underlying principle, the PPP approach forecasts that the exchange rate will change to offset price changes due to inflation. For example, suppose that prices in the U.S. are expected to increase by 4% over the next year while prices in Canada are expected to rise by only 2%. The inflation differential between the two countries is:

4% - 2% = 2%

This means that prices in the U.S. are expected to rise faster relative to prices in Canada. In this situation, the purchasing power parity approach would forecast that the U.S. dollar would have to depreciate by approximately 2% to keep prices between both countries relatively equal. So, if the current exchange rate was 90 cents U.S. per one Canadian dollar, then the PPP would forecast an exchange rate of:

(1 + 0.02) x (US$0.90 per CA$1) = US$0.918 per CA$1

Meaning it would now take 91.8 cents U.S. to buy one Canadian dollar.

One of the most well-known applications of the PPP method is illustrated by the Big Mac Index, compiled and published by The Economist. This light-hearted index attempts to measure whether a currency is undervalued or overvalued based on the price of Big Macs in various countries. Since Big Macs are nearly universal in all the countries they are sold, a comparison of their prices serves as the basis for the index. (To learn more, check out The Big Mac Index: Food For Thought.)

Relative Economic Strength Approach
As the name may suggest, the relative economic strength approach looks at the strength of economic growth in different countries in order to forecast the direction of exchange rates. The rationale behind this approach is based on the idea that a strong economic environment and potentially high growth is more likely to attract investments from foreign investors. And, in order to purchase investments in the desired country, an investor would have to purchase the country's currency - creating increased demand that should cause the currency to appreciate.

This approach doesn't just look at the relative economic strength between countries. It takes a more general view and looks at all investment flows. For instance, another factor that can draw investors to a certain country is interest rates. High interest rates will attract investors looking for the highest yield on their investments, causing demand for the currency to increase, which again would result in an appreciation of the currency.

Conversely, low interest rates can also sometimes induce investors to avoid investing in a particular country or even borrow that country's currency at low interest rates to fund other investments. Many investors did this with the Japanese yen when the interest rates in Japan were at extreme lows. This strategy is commonly known as the carry-trade. (Learn more about the carry trade in Profiting From Carry Trade Candidates.)

Unlike the PPP approach, the relative economic strength approach doesn't forecast what the exchange rate should be. Rather, this approach gives the investor a general sense of whether a currency is going to appreciate or depreciate and an overall feel for the strength of the movement. This approach is typically used in combination with other forecasting methods to develop a more complete forecast.

Econometric Models
Another common method used to forecast exchange rates involves gathering factors that you believe affect the movement of a certain currency and creating a model that relates these factors to the exchange rate. The factors used in econometric models are normally based on economic theory, but any variable can be added if it is believed to significantly influence the exchange rate.

As an example, suppose that a forecaster for a Canadian company has been tasked with forecasting the USD/CAD exchange rate over the next year. He believes an econometric model would be a good method to use and has researched factors he thinks affect the exchange rate. From his research and analysis, he concludes the factors that are most influential are: the interest rate differential between the U.S. and Canada (INT), the difference in GDP growth rates (GDP), and income growth rate (IGR) differences between the two countries. The econometric model he comes up with is shown as:

USD/CAD (1-year) = z + a(INT) + b(GDP) + c(IGR)

We won't go into the details of how the model is constructed, but after the model is made, the variables INT, GDP and IGR can be plugged into the model to generate a forecast. The coefficients a, b and c will determine how much a certain factor affects the exchange rate and direction of the effect (whether it is positive or negative). You can see that this method is probably the most complex and time-consuming approach of all the ones discussed so far. However, once the model is built, new data can be easily acquired and plugged into the model to generate quick forecasts.

Time Series Model
The last approach we'll introduce you to is the time series model. This method is purely technical in nature and is not based on any economic theory. One of the more popular time series approaches is called the autoregressive moving average (ARMA) process. The rationale for using this method is based on the idea that past behavior and price patterns can be used to predict future price behavior and patterns. The data you need to use this approach is simply a time series of data that can then be entered into a computer program to estimate the parameters and essentially create a model for you.

Bottom Line
Forecasting exchange rates is a very difficult task, and it is for this reason that many companies and investors simply hedge their currency risk. However, there are others who see value in forecasting exchange rates and want to understand the factors that affect their movements. For people who want to learn to forecast exchange rates, these four approaches are a good place to start. (Learn more about currencies and forex trading in Top 10 Forex Trading Rules.)

Related Articles
  1. Economics

    Why the Euro Failed to Become the World's Reserve Currency

    Examine the current state of the U.S. dollar as the world's reserve currency; learn the major reasons why the euro has failed to replace it in that capacity.
  2. Investing Basics

    How to Use Boring CDs to Diversify

    Markets are volatile and are in for more punishment. CDs can help investors earn some interest while they're waiting out the storm.
  3. Economics

    These Will Be the World's Top Economies in 2020

    Discover the current economic forces that are anticipated to significantly shift the landscape of the world's most powerful economies over the next decade.
  4. Investing

    Have Commodities Bottomed?

    Commodity prices have been heading lower for more than four years, being the worst performing asset class of 2015 with more losses in cyclical commodities.
  5. Fundamental Analysis

    Emerging Markets: Analyzing Colombia's GDP

    With a backdrop of armed rebels and drug cartels, the journey for the Colombian economy has been anything but easy.
  6. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  7. Fundamental Analysis

    Use Options Data To Predict Stock Market Direction

    Options market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
  8. Economics

    Is the U.S. Economy Ready for Liftoff?

    The Fed continues to delay normalizing rates, citing inflation concerns and “global economic and financial developments” in explaining its rationale.
  9. Investing News

    Thursday Intel: Will Q4 Offer a Fresh Start?

    Investor hopes for a fresh start to the world economy in this quarter may be misplaced.
  10. Economics

    What's Economic Capital?

    While regulatory and economic capital use some of the same measurements of risk to determine how much capital a firm should hold in reserve, economic capital uses more realistic measures.
  1. Who decides to print money in Canada?

    In Canada, new money comes from two places: the Bank of Canada (BOC) and chartered banks such as the Toronto Dominion Bank ... Read Full Answer >>
  2. What are the best ways to sell an annuity?

    The best ways to sell an annuity are to locate buyers from insurance agents or companies that specialize in connecting buyers ... Read Full Answer >>
  3. Is Argentina a developed country?

    Argentina is not a developed country. It has one of the strongest economies in South America or Central America and ranks ... Read Full Answer >>
  4. Are Social Security benefits adjusted for inflation?

    Social Security benefits are adjusted for inflation. This adjustment is known as the cost of living adjustment (COLA). For ... Read Full Answer >>
  5. When has the United States run its largest trade deficits?

    In macroeconomics, balance of trade is one of the leading economic metrics that determines the trading relationship of a ... Read Full Answer >>
  6. Which is more important to a nation's economy, the balance of trade or the balance ...

    There is no question the composition of a country's balance of payments is more important than its balance of trade. This ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  2. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
  3. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  4. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  5. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  6. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!