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 markets
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/