Many people and companies involved with the Forex markets are interested in the direction of currency exchange rates. Making an accurate forecast to guide your investment decision making is important to maximize your profits while minimizing your risk in your trading. There are many different methods of preparing these forecasts and no one method has yet proved to be the best. This illustrates the difficulty of the exercise and here are some of the most popular and widely used methods.
Purchasing Power Parity (PPP)
Purchasing Power Parity (PPP) is given a lot of importance in economics textbooks and is based on the principle of the Law of One Price which states that the same goods in different countries should have the same price. By this logic, the price of a hamburger in Japan should be identical with the price in the United States after taking into account exchange rates and excluding transportation costs. If prices change due to inflation, the exchange rate should change to reflect the price change. For example, if prices in the United States are expected to increase by 4% because of inflation while prices in Japan are expected to increase only by 2%, the difference in the rates of inflation is 2%. The PPP approach would forecast that the U.S. dollar should depreciate by 2% against the Japanese yen in order to maintain the parity between the two countries. A striking example of the use of this approach is the Big Mac index which is calculated and published by the well known news magazine The Economist. Because a Big Mac hamburger is almost identical throughout the world, a comparison of the prices in different countries is a pretty reasonable indicator of whether currencies are overvalued or undervalued.
Relative Economic Strength Approach
This method studies the strength of economic growth for different countries to be able to forecast the direction of changes in currency exchange rates. The method is based on the presumption that strong economic environments are conducive to high growth and are more likely to attract foreign investors. Because these investors have to buy the currency of that country in order to make an investment, the increased demand should result in the appreciation of that currency. The method also goes beyond relative economic strength and studies the flow of all investments. For instance, another important factor in investment is the interest rate differential and high interest rates mean higher investment returns. Unlike the PPP approach, this approach does not give an indication of what the future interest rate is likely to but only indicates the direction and the strength of the trend. This is why it is often used in combination with other forecasting methods to provide the basis for a more complete and accurate forecast.
This method of forecasting exchange rate movements consists of identifying factors that you believe will feature in the movement of a particular currency and then creating a model in which these factors are related to the exchange rates. The factors used in the modeling exercise are derived from economic theory but you are free to incorporate any factor that you believe may have an influence on the exchange rate. For instance, you may be studying the exchange rate between the U.S. dollar and the Euro and believe in econometric modeling. You may believe that the important factors are interest rate differentials and the differences in the GDP growth rate and the growth rate of income. It is possible to build a forecasting model based on these factors and each factor can be weighted to reflect its significance. As you will observe, this approach is both complex and time intensive but is highly flexible in that any changes can quickly be plugged in to determine the impact on the exchange rate.
Why interest rates are important
Probably the most important influence on the Forex markets are interest rate changes made by any of the major central banks in the world. These changes are themselves made in response to other major economic factors and this is why they have an immediate and profound impact on the market. Surprise rate changes can have a big impact on trading profitability which is why traders need to understand how to predict and benefit from these changes. While it may seem pretty self evident that the highest interest rates will deliver the highest returns, but they not be quite as simple as this. Often, the beneficial effect of high interest rates can be offset by currency rate fluctuations. So buying the currency with the highest interest rates is not automatically the best investment. You can get a pretty good idea of what a particular central bank is going to do by keeping an eye on indicators such as consumer spending and job employment levels. For instance, it is a pretty fair assessment that the U.S. Federal Reserve is unlikely to slow down quantitative easing and the purchase of securities unless the employment rate reaches their targeted level.
If you are faced with a surprise change in central bank policy ( and this is bound to happen no matter how accurate your forecasting methods), put yourself in a position to react immediately because of the markets are going to move at lightning speed. If the interest rate is raised, traders will be buying and the currency will appreciate. Conversely, if it is lowered, traders will be selling and the currency will depreciate. Because of the traders in the market will react in the same manner, there are significant profit opportunities if you are ahead of the pack. However, you may also benefit from a sharp trend reversal because the markets will first be influenced by trader’s sentiment but could then correct themselves as the logic takes root.