Exchange Rate Forecasting

EXCHANGE RATE FORECASTING
International transactions are usually settled in the near

future. Exchange rate forecasts are necessary to
evaluate the foreign denominated cash flows involved in
international transactions.
Thus, exchange rate forecasting is very important to
evaluate the benefits and risks attached to the
international business environment.
There are two pure approaches to
forecasting foreign exchange rates:
(1) The fundamental approach.

(2) The technical approach.
Fundamental Approach:
The fundamental approach is based on a wide range of data

regarded as fundamental economic variables that determine
exchange rates. These fundamental economic variables are taken
from economic models.
Usually included variables are GNP, consumption, trade balance,
inflation rates, interest rates, unemployment, productivity indexes,
etc. In general, the fundamental forecast is based on structural
(equilibrium) models. These structural models are then modified to
take into account statistical characteristics of the data and the
experience of the forecasters.
Fundamental Approach: Forecasting
at Work
Practitioners use the fundamental approach to generate

equilibrium exchange rates. The equilibrium exchange rates
can be used for projections or to generate trading signals. A
trading signal can be generated every time there is a
significant difference between the forecasted exchange rate
and the exchange rate observed in the market. If there is a
significant difference between the forecast rate and the
actual rate, the practitioner should decide if the difference is
due to a mispricing or a heightened risk premium. If the
practitioner decides the difference is due to mispricing, then
a buy or sell signal is generated.
There are two kinds of forecasts
In-sample
Out-of-sample
The first type of forecasts works within the sample at hand, while the
latter works outside the sample.
In-sample forecasting does not attempt to forecast the future path of
one or several economic variables. This sample forecast method uses
today's information to forecast what today's spot rates should be. Thus
the forecast will be within in the sample. The fundamental approach
generates an equilibrium exchange rate. The foreign exchange rate in-
sample fundamental forecasts are interpreted as equilibrium exchange
rates. Equilibrium exchange rates can be used to generate trading
signals.
On the other hand, out-of sample forecasting
attempts to use today’s information to forecast the
future behavior of exchange rates. That is, we
forecast the path of exchange rates outside of our
sample. In general, at time t, it is very unlikely that
we know the inflation rate for time t+1. That is, in
order to generate out-of-sample forecasts, it will be
necessary to make some assumptions about the
future behavior of the fundamental variables.
Technical Approach
The technical approach (TA) focuses on a smaller

subset of the available data. In general, it is based on
price information. The analysis is "technical" in the
sense that it does not rely on a fundamental analysis
of the underlying economic determinants of exchange
rates or asset prices, but only on extrapolations of
past price trends. Technical analysis looks for the
repetition of specific price patterns. Technical analysis
is an art, not a science.
Exchange Rate Forecast: Models
i. Purchasing Power Parity (PPP) Model
ii. Uncovered Interest Rate Parity (UIP) Model
iii. Random Walk Model

Purchasing Power Parity (PPP)
Model
Purchasing power parity (PPP) is a theory which
states that exchange rates between currencies are
in equilibrium when their purchasing power is the
same in each of the two countries. This means
that the exchange rate between two countries
should equal the ratio of the two countries' price
level of a fixed basket of goods and services.
When a country's domestic price level is
increasing (i.e., a country experiences inflation),
that country's exchange rate must depreciated in
order to return to PPP.
The basis for PPP is the "law of one price". In the absence
of transportation and other transaction costs, competitive
markets will equalize the price of an identical good in two
countries when the prices are expressed in the same
currency. For example, a particular TV set that sells for
750 Canadian Dollars [CAD] in Vancouver should cost 500
US Dollars [USD] in Seattle when the exchange rate
between Canada and the US is 1.50 CAD/USD. If the price
of the TV in Vancouver was only 700 CAD, consumers in
Seattle would prefer buying the TV set in Vancouver.
There are three caveats with this
law of one price
(1) As mentioned above, transportation costs,
barriers to trade, and other transaction costs,
can be significant.
(2) There must be competitive markets for the
goods and services in both countries.
(3) The law of one price only applies to tradable
goods; immobile goods such as houses, and
many services that are local, are of course not
traded between countries.

How is PPP calculated?

The simplest way to calculate purchasing power parity
between two countries is to compare the price of a
"standard" good that is in fact identical across countries.
Every year The Economist magazine publishes a light-
hearted version of PPP: its "Hamburger Index" that
compares the price of a McDonald's hamburger around the
world. More sophisticated versions of PPP look at a large
number of goods and services. One of the key problems is
that people in different countries consumer very different
sets of goods and services, making it difficult to compare
the purchasing power between countries.
Uncovered Interest Rate Parity (UIP)
Model
• A parity condition stating that the difference in
interest rates between two countries is equal to
the expected change in exchange rates between
the countries’ currencies. If this parity does not
exist, there is an opportunity to make a profit.
•
"i1" represents the interest rate of country 1

"i2" represents the interest rate of country 2
"E(e)" represents the expected rate of change in
the exchange rate.
For example, assume that the interest rate in
America is 10% and the interest rate in Canada is
15%. According to the uncovered interest rate
parity, the Canadian dollar is expected to
depreciate against the American dollar by
approximately 5%. Put another way, to convince
an investor to invest in Canada when its
currency depreciates, the Canadian dollar interest
rate would have to be about 5% higher than the
American dollar interest rate.
Random Walk Theory
The theory that stock price changes have the same

distribution and are independent of each
other, so the past movement or trend of a stock price
or market cannot be used to predict its future
movement.
In short, this is the idea that stocks take a random and
unpredictable path. A follower of the random walk theory
believes it's impossible to outperform the market without
assuming additional risk. Critics of the theory, however,
contend that stocks do maintain price trends over time - in
other words, that it is possible to outperform the market by
carefully selecting entry and exit points for equity investments.
This theory raised a lot of eyebrows in 1973 when author

Burton Malkiel wrote "A Random Walk Down Wall Street",
which remains on the top-seller list for finance books.

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EXCHANGE RATE FORECASTING

International transactions are usually settled in the near

(1) The fundamental approach.

The fundamental approach is based on a wide range of data

Practitioners use the fundamental approach to generate

The technical approach (TA) focuses on a smaller

ii. Uncovered Interest Rate Parity (UIP) Model

iii. Random Walk Model

"i1" represents the interest rate of country 1

The theory that stock price changes have the same

This theory raised a lot of eyebrows in 1973 when author

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