Exchange rate forecasting methods
Dollars, and euros, and yen. Oh my!
If you’re trying to predict how your money will perform against other currencies in the future, you’re not alone. Forecasting can assist in minimising risk and maximising returns. However, forecasting is a multi-faceted task, and there are a variety of methods in use today. Below is a list of the most popular techniques which may help you to make an informed decision when selecting a forecasting methodology.
About the modelsOver seven years ago, researchers conclusively proved that seemingly unpredictable variables are actually predictable--including currency exchange rates.1 In the years that followed, countless businesses developed complex models that take into account vast amounts of historical data as well as current insights from expert economists. This allows them to quickly modify models by adjusting various factors and the coefficients.
When exchanging currencies, it’s important to keep in mind that short-term fluctuations can be driven by what’s happening in the news: interest rate expectations, unemployment rates, political events like Brexit and even natural disasters can all affect the daily rates. Forecasting models aim to create a long-term picture (4-7 years).
ARIMA time series models
Many statistical models these days are based on Autoregressive Integrated Moving Average (ARIMA) calculations. 2 These models are usually data-based in nature and don’t necessarily abide by any particular economic theory. Instead, they take into consideration historical influences in order to separate seemingly unattributable fluctuations from consistent and relevant patterns. They can also accurately chart seasonal influences like tourism. Using extrapolation, the models allow longer term forecasts to a degree.
Purchasing Power Parity (PPP)
PPP is an economic theory that takes into account the relative cost of a sample of items in one country compared to another. (For instance, economists might consider the cost of a pen, in Australia versus China.) PPP is based on the Law of One Price.3 The Law of One Price stipulates that when transport and transaction costs are eliminated, the price of a pen in China should be the same as the price of a pen in Australia.
So when a country is experiencing inflation, the price of the pen will go up domestically, and their currency must depreciate to return to PPP. When basing a forecast on these factors, it’s easier to take into account inflation and the impact of artificially inflated currencies.
Relative economic strengthA forecast based on relative economic strength takes a general view of two markets comparing investments, interest rates, and economic growth. It won’t forecast the rates themselves but can be used with other models to provide insight into the trend.
When evaluating these methods for yourself, it’s important to keep in mind that foreign exchange markets can be very volatile. When looking to lower risk, some experts prefer to hedge their currency exposure rather than relying exclusively on models and forecasts.
What the experts take into account
Many professional forex traders look at macroeconomic factors to form a basis for their forecasts including:
- Capital markets. Forex traders rely on the constant stream of news related to stocks, bonds and market events like major sell-offs to inform their decisions
- Reserve bank announcements and interest rate changes. Generally speaking, higher interest rates attract foreign investment, but inflation levels can mitigate the strength of this correlation.
- Imports and exports. Each country has its critical trade industries which affect the global perception of that currency. The balance of imports to exports in international trade is a strong indicator of growth
- Government stability and the political environment. Elections, policy changes, and coups can have major impacts on currencies. For instance after Brexit, the pound reached its lowest level against the US dollar in thirty years
- Economic reports. Savvy forex traders maintain a calendar of significant government reports such as GDP, inflation rates, and employment trends.
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