Forecasting exchange rates can help minimize risks and maximize returns. It’s not easy to do, however, which is why many companies and investors hedge their currency risk. Here are three popular methods for forecasting exchange rates that provide a good place to start.The purchasing power parity, possibly the best-known method, is based on the theoretical law that identical goods in different countries should have identical prices. A pencil in Canada should cost the same as it does in the U.S. According to the PPP approach, currencies will adjust according to changes in their purchasing power. A well-known application of the PPP approach is the Big Mac Index, which measures whether a currency is under or overvalued based on the price of Big Macs in various countries. Since Big Macs should cost the same everywhere they’re sold, comparing their prices provides the basis for the index. The relative economic strength approach compares growth in different countries to forecast the direction of exchange rates. A strong economy and high growth attracts foreign investors. To buy investments in the desired country, investors must buy its currency, increasing demand for that currency. The relative economic strength approach provides a sense of whether a currency will appreciate or depreciate. Econometric models involve gathering factors that should affect the movement of a certain currency, then creating a model that relates them to the exchange rate. For example, a Canadian company wanting to forecast exchange rates with the U.S. over the next year may use factors like interest rate differential between the countries, plus differences in GDP and income growth. It then plugs them into an econometric model to make a forecast.