3 Common Ways to Forecast Currency Exchange Rates

Being able to forecast exchange rates provides insight into the movement of the global economy. Many methods of forecasting currency exchange rates exist, including purchasing power parity, relative economic strength, and econometric models.

These strategies for forecasting currency movements can be broadly categorized as forms of fundamental or technical analysis. Some analysts also make use of market-based analysis and new-based analysis. Often, a combination of tools provides the most accurate forecast of how exchange rates will vary over time.

Key Takeaways

Currency exchange rate forecasts help brokers, businesses, governments, and other organizations maximize profits and minimize risks in a global economy.
Purchasing power parity looks at the prices of goods in different countries and is a widely used forecasting method.
The relative economic strength approach compares levels of economic growth across countries to predict how exchange rates will change.
Econometric models attempt to analyze how a wide range of economic variables can be used to predict trends in currency markets.
Many methods of forecasting exchange rates can broadly categorized as fundamental or technical analysis.

Why Forecast Exchange Rates

Understanding how exchange rates are likely to move can help organizations and individuals make informed decisions about when, when, and how to use their money. This can help to minimize risks and maximize returns in a global economy where economic changes in one country can create impacts around the world.

Some groups that can benefit from exchange rate forecasting include:

Brokers
Businesses
Traders
Government agencies
Investment banks

Fundamental vs. Technical Analysis

Methods for forecasting exchange rates generally fall into one of two categories: fundamental analysis or technical analysis. Both types of analysis attempt to predict price movements, and they can be used by individuals, businesses, and institutions to identify opportunities for making a profit in the global economy.

Fundamental Analysis

Fundamental analysis looks at economic factors that reflect the intrinsic value of an asset. In the case of exchange rates, the asset would be a currency. Areas of fundamental analysis include:

Gross Domestic Product (GDP)
Consumer Price Index (GDP)
Purchasing power parity (PPP)
Interest rates

Technical Analysis

Technical analysis, on the other hand, looks at statistical changes to evaluate an asset’s price. When forecasting exchange rates, this means looking at trends in exchange rates over time to predict the strength of one currency relative to another.

This often involves plotting trends in currency prices and exchange rates against factors such as inflation, interest rates, and GDP growth. These models can then be analyzed for trendlines and patterns that can be used to forecast future changes.

Exchange rates can also be predicted through market analysis, which looks at stock market trends, or new-based analysis, which tracks global current events and their impact on currencies.

Common Ways to Forecast Exchange Rates

Fundamental and technical analysis reflect different ways of analyzing economic patterns. In practice, many forecasters will make use of both types of analysis to create the most accurate predictions possible.

Three common metrics used to forecast the movements of exchange rates are purchasing power parity, relative economic strength, and econometric modeling.

Purchasing Power Parity

The purchasing power parity (PPP) is one of the most popular methods for exchange rate forecasting. The PPP forecasting approach is based on the theoretical law of one price, which states that identical goods in different countries should have identical prices in a free market.

According to purchasing power parity, a pencil in Canada should be the same price as a pencil in the United States 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 inexpensive pencils in one country and sell them in another for a profit.

The PPP approach forecasts that the exchange rate will change to offset price changes due to inflation based on this underlying principle.

Example of Purchasing Power Parity

Suppose that the prices of pencils 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:

$\begin{aligned} &4\% – 2\% = 2\% \\ \end{aligned}$

This means that prices of pencils 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 pencil 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:

$\begin{aligned} &( 1 + 0.02 ) \times ( \text{US \$}0.90 \text{ per CA \$}1 ) = \text{US \$}0.92 \text{ per CA \$}1 \\ \end{aligned}$

In other words, an analysis using purchasing power parity would predict a new exchange rate of $0.92 USD to $1 CAD.

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 lighthearted 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.

However, purchasing power parity assumes a free and logical market that does not always exist in the real world. Consumer behavior, inflation, transport costs, and tariffs can all impact prices, meaning that the same goods often will vary in price around the world, even once exchange rates are taken into account.

Relative Economic Strength

The relative economic strength approach looks at the strength of economic growth in different countries to forecast the direction of exchange rates. The rationale behind this approach is that a strong economic environment and potentially high growth are more likely to attract investments from foreign investors. 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 only look at the relative economic growth 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.

The relative economic strength method doesn’t forecast what the exchange rate should be, unlike the PPP approach. Rather, this approach forecasts the strength of a currency’s movement in one direction or another, providing a general sense of whether a currency is going to appreciate or depreciate. It is typically used in combination with other forecasting methods to produce a complete result.

Econometric Modeling

Another common method used to forecast exchange rates involves gathering factors that might affect currency movements and creating a model that relates these variables to the exchange rate. The factors used in econometric models are typically based on economic theory, but any variable can be added if it is believed to significantly influence the exchange rate.

Some factors used in econometric modeling include:

Interest rates
GDP
Income growth
Stock market growth
Unemployment rates

Economic metric models can provide insights into exchange rate trends based on trends in economic patterns. However, like all statistical tools, they do not necessarily provide insight into why these trends occur. When using econometric models, it is important not to confuse correlation and causation.

Example of Econometric Modeling

Suppose that a forecaster for a Canadian company has been tasked with forecasting the USD/CAD exchange rate over the next year.

From their research and analysis, the forecaster concludes that the factors that most impact exchange rates are:

The econometric model the researchers creates is shown as:

$\begin{aligned} &\text{USD/Cad(1 – Year)} = z + a( \text{INT} ) + b( \text{GDP} ) + c( \text{IGR} ) \\ &\textbf{where:} \\ &z = \text{Constant baseline exchange rate} \\ &a, b \text{ and } c = \text{Coefficients representing relative} \\ &\text{weight of each factor} \\ &\text{INT} = \text{Difference in interest rates between} \\ &\text{U.S. and Canada} \\ &\text{GDP} = \text{Difference in GDP growth rates} \\ &\text{IGR} = \text{Difference in income growth rates} \\ \end{aligned}$

After the model is created, the variables INT, GDP, and IGR can be plugged in to generate a forecast. The coefficients a, b, and c will determine how much a certain factor affects the exchange rate and the direction of that effect (whether it is positive or negative).

This method is complex and time-consuming, but once the model is built, new data can be easily acquired and plugged in to generate quick forecasts.

What Is Purchasing Power Parity?

Purchasing power parity is a macroeconomic theory that compares the economic productivity and standard of living between two countries by looking at the ability of their currencies to purchase the same “basket of goods.” Under this theory, two currencies are in equilibrium when the price of the same basket of goods is equal in both currencies, accounting for exchange rates.

Who Needs to Forecast Exchange Rates?

Being able to forecast exchange rates provides insight into the movement of the global economy. This information is necessary for individuals such as investors, brokers, and forex traders; business of any size that have an international presence; and large organizations such as central banks, governments, and financial institutions.

Why Is Forecasting Exchange Rates a Challenge?

Forecasting exchange rates is a challenge because of the variety of factors that impact economies. Interest rates, inflation, and rates of economic growth vary from country to country, and both local and worldwide events can change them in unexpected ways. Because of the interconnected nature of the global economy, economic changes in one country can have a global impact on economic factors such as exchange rates.

The Bottom Line

Forecasting exchange rates is a difficult task. As a result, many companies and investors simply hedge their currency risk rather than attempting to predict how currencies will move. However, those who see value in forecasting exchange rates and want to understand the factors that affect their movements can use a variety of fundamental and technical analysis techniques to begin their research.