APPROACHES IN PREDICTING CURRENCY CHANGES
Many entities, whether an investor or business, are interested in learning to predict the direction of exchange rates. Doing so will help them in decision making process in order to reduce risks and optimize their returns. You have read numerous methods of forecasting exchange rates. But this article will highlight four of the most popular approaches.
Econometric Models. Using econometric models entail collating factors affecting the movement of a particular currency, according to an individual’s perception, as well as making a model linking these factors to the exchange rate. The factors considered in econometric models are usually based on economic theory, but any variable may be added if it is said to significantly influence the exchange rate. Employing this approach in forecasting may be one of the most complicated and time-consuming methods. But after forming the model, new figures can be easily obtained and integrated into the model to formulate quick forecasts.
Purchasing Power Parity (PPP). As stipulated in the theoretical Law of One Price, it stipulates identical products in several countries should have identical prices. In other, their prices should have no arbitrage opportunity for an individual to buy a particular product cheap in one nation and sell those in another to gain profit. This approach predicts the exchange rate will change to offset price changes due to inflation.
One of the most well-known applications of this method is displayed by the Big Mac Index. Collated and published by The Economist, the index endeavors to gauge whether a specific currency is undervalued or overvalued according to the rate of Big Macs in many countries. Comparing these prices serves as the basis for the index since Big Macs are almost universal in all the countries they are sold.
Relative Economic Strength Approach. This method looks at the strength of economic growth in various nations to predict the direction of exchange rates. The approach is anchored on the idea a firm economic environment and potentially high growth is more likely to gain investments from foreign investors. And to purchase the investments in the chosen country, an investor needs to buy the country’s currency; thus, creating increased demand which should cause the currency to appreciate.
This approach does not only account the relative economic strength of two countries, but also all investment flows. Unlike the PPP approach, it does not forecast what the rate should be, but gives an overview sense as to whether a currency will appreciate or depreciate, as well as the overall feel for the movement’s strength.
Time Series Model. Since the model is purely technical in nature, it does not rely on any economic theory. The autoregressive moving average (ARMA) process is one of the more popular time series approaches. The idea behind this approach is the previous behavior and price patterns can be utilized to forecast future price behavior and patterns. An investor or analyst needs to gather a time series of data that can be entered into a software to estimate parameters to come up with a suitable model.
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