1. Forecasting Exchange Rates

2. Two Approaches to Forecasting
Fundamental Analysis
Examines economic relationships and financial data to arrive at a forecast.
Short term horizons: Asset Choice Model
Long term horizons: Parity Models
Technical Analysis
Relies on historical price patterns to arrive at a forecast.
Generally very short term horizons

3. Fundamental Analysis: Short Trerm
Asset Choice:
Examines why one currency might be preferred over others. Variables include:
Relative interest rates (current and anticipated)
Political/country risk
Safe haven effects
Carry trade strategies and carry trade unwinds
Essentially, trying to identify why the demand for a currency will change.

4. Fundamental Analysis: Long Term
Parity Models
Through these models one attempts to calculate an “equilibrium” exchange rate in the future.
Analysis built on “long standing” economic theories of exchange rate determination.
Purchasing Power Parity Model
International Fisher Effect

5. Purchasing Power Parity
One of the oldest exchange rate models.
Assumes that exchange rates will change to offset relative prices levels between countries.
Countries with relatively high rates of inflation will show currency depreciation
Countries with relatively low rates of inflation will experience currency appreciation
In equilibrium, the amount of depreciation (or appreciation) will be equal to the inflation differential.

6. Purchasing Power Parity Example
Assume:
Spot GBP/USD: $1.80
Forecasted UK rate of inflation (annualized) for the next 12 months: 2.5%
Forecasted US rate of inflation (annualized) for the next 12 months: 1.0%
PPP Spot GBP/USD Forecast
1 year change in GBP: $1.80 x .015 =
1 year spot GBP: $ = $1.773
6 month GBP: $1.80 – (0.027/2) = $1.80 – = $1.7865

7. Purchasing Power Parity Example
Assume:
Spot USD/CAD: 1.20
Forecasted CAD rate of inflation (annualized) for the next 12 months: .5%
Forecasted US rate of inflation (annualized) for the next 12 months: 2.5%
PPP Spot USD/CAD Forecast
1 year change in CAD: 1.20 x .020 =
1 year spot CAD: = 1.176
6 month CAD: 1.20 – (.024/2) = = 1.188

8. International Fisher Effect
Assume that exchange rates will change in direct proportion to relative differences in long term interest rates.
Assumes that long term interest rates capture the market’s expectation for inflation.
Countries with relatively high rates of long term interest rates (i.e., high inflation) will show currency depreciation.
Countries with relatively low rates of long term interest rates (i.e., low inflation) will show currency appreciation.
In equilibrium, the amount of depreciation (or appreciation) will be equal to the long term interest rate differential.

9. International Fisher Effect Example
Assume:
Spot EUR/USD = $1.50
Current 1 year German Government Bond rate = 2.15%
Current 1 year U.S. Government Bond rate = 4.5%
IFE Spot EUR/USD Forecast
1 year change in EUR = $1.50 x =
1 year spot EUR = $ = $

10. International Fisher Effect Example
Assume:
Spot USD/JPY = 98.00
Current 1 year Japanese Government Bond rate = 0.5%
Current 1 year U.S. Government Bond rate = 4.5%
IFE Spot USD/JPY Forecast
1 year change in JPY = x 0.04 = 3.92
1 year spot JPY = =

11. Technical Analysis
Uses charts and price patterns to forecast future moves in spot exchange rates.
Looks for price patterns that have historically signed a future move.
Assume historical relationship will result in similar moves in the future.
Not interested in “explaining” the source of the expected future move.
Not interested in financial information or news.

12. Technical Analysis
Go to FXStreet.com to review some technical patterns.