Forecasting Exchange

Rates
Two Approaches to
Forecasting

Fundamental Analysis

Examines economic relationships and

fnancial data to arrive at a forecast.

Short term horizons Asset !hoice "odel

#ong term horizons $arity "odels

Technical Analysis

Relies on historical price patterns to

arrive at a forecast.

%enerally very short term horizons

Fundamental Analysis Short
Trerm

Asset !hoice

Examines why one currency might &e

preferred over others. 'aria&les include

Relative interest rates (current and

anticipated)

$olitical*country ris+

Safe haven e,ects

!arry trade strategies and carry trade unwinds

Essentially- trying to identify why the

demand for a currency will change.
Fundamental Analysis #ong
Term

$arity "odels

Through these models one attempts to

calculate an .e/uili&rium0 exchange
rate in the future.

Analysis &uilt on .long standing0

economic theories of exchange rate
determination.

$urchasing $ower $arity "odel

1nternational Fisher E,ect

$urchasing $ower $arity

2ne of the oldest exchange rate models.

Assumes that exchange rates will change

to o,set relative prices levels &etween
countries.

!ountries with relatively high rates of in3ation

will show currency depreciation

!ountries with relatively low rates of in3ation

will experience currency appreciation

1n e/uili&rium- the amount of depreciation

(or appreciation) will &e e/ual to the
in3ation di,erential.
$urchasing $ower $arity
Example

Assume

Spot %4$*5S6 78.9:

Forecasted 5; rate of in3ation (annualized) for the

next 8< months <.=>

Forecasted 5S rate of in3ation (annualized) for the

next 8< months 8.:>

$$$ Spot %4$*5S6 Forecast

8 year change in %4$ 78.9: x .:8= ? :.:<@.

8 year spot %4$ 78.9: A .:<@ ? 78.@@B

C month %4$ 78.9: D (:.:<@*<) ? 78.9: D :.:8B=

? 78.@9C=
$urchasing $ower $arity
Example

Assume

Spot 5S6*!A6 8.<:

Forecasted !A6 rate of in3ation (annualized)

for the next 8< months .=>

Forecasted 5S rate of in3ation (annualized)

for the next 8< months <.=>

$$$ Spot 5S6*!A6 Forecast

8 year change in !A6 8.<: x .:<: ? :.:<E.

8 year spot !A6 8.<: A :.:<E ? 8.8@C

C month !A6 8.<: D (.:<E*<) ? 8.<: A .:8< ?

8.899
1nternational Fisher E,ect

Assume that exchange rates will change in

direct proportion to relative di,erences in long
term interest rates.

Assumes that long term interest rates capture the

mar+etFs expectation for in3ation.

!ountries with relatively high rates of long term

interest rates (i.e.- high in3ation) will show
currency depreciation.

!ountries with relatively low rates of long term

interest rates (i.e.- low in3ation) will show
currency appreciation.

1n e/uili&rium- the amount of depreciation (or

appreciation) will &e e/ual to the long term
interest rate di,erential.
1nternational Fisher E,ect
Example

Assume

Spot E5R*5S6 ? 78.=:

!urrent 8 year %erman %overnment 4ond rate

? <.8=>

!urrent 8 year 5.S. %overnment 4ond rate ?

E.=>

1FE Spot E5R*5S6 Forecast

8 year change in E5R ? 78.=: x :.:<B= ?

:.:B=<=

8 year spot E5R ? 78.=: G .:B=<= ? 78.=B=<=

1nternational Fisher E,ect
Example

Assume

Spot 5S6*H$I ? J9.::

!urrent 8 year Hapanese %overnment 4ond

rate ? :.=>

!urrent 8 year 5.S. %overnment 4ond rate

? E.=>

1FE Spot 5S6*H$I Forecast

8 year change in H$I ? J9.:: x :.:E ? B.J<

8 year spot H$I ? J9.:: A B.J< ? JE.:9

Technical Analysis

5ses charts and price patterns to forecast

future moves in spot exchange rates.

#oo+s for price patterns that have historically

signed a future move.

Assume historical relationship will result in

similar moves in the future.

Kot interested in .explaining0 the source

of the expected future move.

Kot interested in fnancial information or

news.
Technical Analysis

%o to FLStreet.com to review some

technical patterns.

http**www.fxstreet.com*ratesAcharts*
forexAcharts*